Why gold mutual funds outshine gold accumulation plans?
Buying gold jewelry was a BIG (expensive) deal for Ruchi ( One of my Investor), just like it
is for most of us. With gold prices at elevated levels of late, a lump
sum purchase was out of question. She was thus looking around for a
product that could facilitate small, staggered purchases of the metal.
That's when she learnt about the gold accumulation plan offered by a
neighborhood jeweler.
All it required was setting aside some amount each month for the next 10
months, EMI style, for the final purchase. A one-month bonus
contribution by the jeweler, and the convenience of buying jewelry from
him at the end of the accumulation phase made a good investment case for
the plan.
She dreamed of walking out thrilled from the jewelers' 11 months later,
holding her brand-new, and shining piece of jewelry. (The jeweler would
be equally thrilled as he would make much more than the bonus in making
charges and margins, and not have to negotiate the price which he would
otherwise have to do, given that you are not left with any other choice
but to purchase jewelry from him)
But all that glitters is not gold, and Ruchi had to learn it the hard
way. And no we aren't talking about purity risk here. That's a real risk
too, but a discussion for some other day.
We are talking about another key gold investment risk which tends to get
ignored by unsuspecting consumers like Ruchi, till the time it all goes
downhill of course, - credit risk. Credit risk is the capacity and/or
willingness of an entity to meet its financial commitments as they
become due. Sure the friendly jeweler has been around for decades and is
someone your family or friends trust and regularly deal with. But it is
prudent to remember that credit profiles are dynamic, they can change,
and they do change.
Fraught with risks and inefficiencies
Firstly, let's understand that these gold accumulation schemes are like
working capital loans for the jeweler, and the bonus contribution he
pays you at the end of the accumulation phase is like paying simple
interest on the money you've provided him over the last few months.
Now the issue is you can never be sure whether the jeweler has kept
enough gold/jewelry as deposit equivalent to the money deposited as he
could also be using the cash flows for other business expenses like
expansion or vendor payments or salaries. In fact, the jeweler might
also use fresh inflows in these gold accumulation schemes to honor
existing scheme commitments. Sometimes this could result in
over-leveraging, a common business error in which planned cash inflows
don't match cash outflows leading to defaults. At the end of the day, a
jeweler is
running a business and a wrong cycle or wrong call can lead to losses
beyond repair, which can even stretch to business failure in a worst
case scenario.
Now, one of the important reasons one invests in gold is that it is free
from counterparty risk. But by enrolling in such a scheme you are
taking a counter party exposure on the jeweler and thus inviting
associated risks. What makes this a grave issue is that there is no
regulatory protection whatsoever to small depositors in these gold
schemes if a jeweler goes bankrupt resulting in the unsuspecting saver
losing his hard earned money.
So till these schemes are better regulated and provide adequate
protection to consumers, there's only one way to approach systematic
gold purchases- Caveat Emptor or Buyer Beware.
Exploring better alternatives
Now, gold is either bought for consumption or investment. Both being
very distinct needs, the traditional view is that physical gold in the
form of jewelry, coins and bars is best suited for adornment and gifting
i.e. self-consumption, while financial forms like gold funds/ETFs are a
preferable avenue for investment
However, we think there is a third way to approach this: systematic
investments over time in the financial form (gold savings funds), only
to be converted to physical form (jewelry/coins) at the time of
consumption.
So how do these gold savings funds work? They are nothing but a logical
extension to gold ETFs. Those who want to invest in gold at regular
intervals in a systematic manner, can consider these funds which operate
like a Fund of Fund and invest their corpus into an underlying gold
ETF.
These funds not only have the 'systematic investment' benefit of the gold accumulation plan, but offer much, much more.
Small, systematic investments: Since they offer SIP
mode of investing, they provide you with the benefit of rupee-cost
averaging and enable investor to save and invest regularly with amounts
as low as Rs. 500 and quantities as less as half a gram. You actually
lock in the gold price and become an owner of the attributable gold
equivalent to the amount of investment.
Price efficiency: The price in gold funds is locked in
as per wholesale rates prevailing on the day of the installment. This is
the ideal way as it averages out your cost as you pay each installment.
In contrast, in most gold accumulation plans the price at which you
would buy gold will be one prevailing at the end of the term. So if you
have started today for a one year plan then you get the gold rate that
would be prevailing at the end of the term i.e. one at the end of 11
months from today. It may benefit you if the gold price is
lower at the end of the term, but will buy you less gold incase prices
go up. If the long term trend of gold prices is observed, the latter is
more likely to happen.
Assured purity and physical backing: All units are backed by physical gold of 24 carat.
Liquidity: Gold accumulation plans are highly illiquid.
Some may even not allow closing before the end of the term. Even if
they allow, you will lose your bonus installment. You can only buy gold
with the accumulated amount and not use it for any other purpose in case
you have an emergency. They would only permit you to buy gold jewelry
(may not even coins and bars) from their stores only. This is because
the jewelry would earn them margins over and above the gold price
(retail mark ups + jewelry making charges + wastage charges). In
contrast, you can sell your gold fund units on any given day and use the
proceeds in any way you wish.
Safety: Gold is held in secured vaults and there is an
insurance cover for the entire gold as well. The gold is held by a Trust
where investors are the beneficial owners; thereby mitigating any
chances of default
Regulation: With mutual funds being regulated entities,
you can be assured that your money is being used for the defined
purpose and not redirected
Not restricted to one jeweler: At the end of the
accumulation phase, you simply sell your gold fund units and use the
money to buy gold jewelry from any jeweler you wish, instead of being
restricted to only one.
Still, some of you might argue that these plans offer slightly better
returns than gold mutual funds. But one shouldn't forget that
these higher returns come riding on the back of higher risk. Which means
yes, there is a higher probability of making some more money, but also
higher chances of losing it all!
We'll leave you with this thought, hoping you make the right choice and
have nothing to lose whenever the next gold accumulation plan by a
jeweler goes bust.
Sources:
Various publications
Disclaimer: The
information provided herein is based on publicly available information and
other sources believed to be reliable, but involve uncertainties that could
cause actual events to differ materially from those expressed or implied in
such statements. The document is given for general and information purpose and
is neither an investment advice nor an offer to sell nor a solicitation. While
due care has been exercised while preparing this document, we do not warrant
the completeness or accuracy of the information. We will not accept any
liability arising from the use of this material. The recipient of this material
should rely on their investigations and take their own professional advice.
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Nice article
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