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Gold ETFs - Tracking Error

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At present, there are 13 gold ETFs and three gold funds of funds

OVER the past few years, gold-backed exchange traded funds (ETFs) have emerged as preferred investment tools for people who want to take advantage of the price rise in the metal without the hassles of physically buying it and preserving it.

Since 2007, when the first gold ETF-benchmark BeES was launched in the country, there has been a steady increase in the investments going into this paper gold. In the past four years, several fund houses launched their gold ETFs and some of them have even launched gold fund of funds, which invest in gold ETFs. At present, there are 13 gold ETFs and three gold fund of funds.

Though all these funds have gold as the underlying asset and they closely track the price movement in the commodity, the net asset value (NAV) of a gold ETF does not exactly reflect the value of the physical gold and the returns from each fund will be slightly different from the other. This is because of the tracking error in the ETF.

The tracking error occurs due to the expenses charged for managing the fund, transaction costs and the portion of the investment held in liquid assets.

The charges for managing the fund are deducted from NAV of the fund. To cover administrative expenses, the fund also holds some amount in cash or liquid funds. This could be a very small portion of the total amount, but still it will affect the ability to fully reflect the price movement in physical gold. The lower the tracking error the better.

When invested for a longer period, a higher expense ratio will have a larger impact on returns.

The expense ratio of Indian gold ETFs range between 1 per cent and 1.5 per cent. When it comes to gold fund of funds, there is an additional expense ratio of 0.5 per cent to 0.75 per cent. So, when one invests in gold ETF through fund of funds, the total expense of the investor would range between 1.5 per cent and 2.25 per cent.

However, both gold ETFs and fund and funds can coexist. Despite having a comparatively higher expense ratio, gold fund of funds enable systematic investment and the investor needs to have only a demat account.

Another important thing one has to look for while investing in gold ETFs is the

i impact cost and this is crucial at the time of redemption. Impact cost is the difference between the bid price and sell price and depends upon the liquidity of the fund and the availability of bidder and seller.

A significantly large fund will have more number of buy and sell orders and, thus, the impact cost will be lower. When a fund has poor buy and sell orders, the impact cost could go up.

 

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