Do Gold and Index ETFs Actually Deliver?
When we talk about Exchange-Traded Funds (ETFs), a few of their features that strike our mind are their low cost, easy-to-understand composition, and simple trading. While Index ETFs have always been popular among investors, Gold ETFs have garnered interest in recent years due to gold prices fluctuating near their all-time highs. But from a long-term investing context, do these ETFs really deliver?
How to Evaluate if the Gold and Index ETFs are Actually Delivering?
Here are some parameters you must track to determine if your ETF delivers:
Tracking Accuracy
Simply check whether the selected gold or Index ETFs are mirroring the performance of their benchmark index, if not outperforming. Use tracking error metrics to compare the performance. It factors in cash holdings, fund expenses, and rebalancing delays for comparison.
Let’s say the ETF you hold delivered 11.7% returns while the benchmark index return stood at 12%. The tracking error here is 0.3%. If, over time, the underperformance margin widens, you may need to turn to a different ETF.
Liquidity in the Market
Whether the ETF you have bought holds potential also relies on how easily it can be bought and sold without affecting its price much. For example, if you have invested in an ETF with poor liquidity, the scheme will have a wider bid-ask spread. If you are unaware of this term, a bid-ask spread is the contrast between the highest price a buyer of the scheme is ready to pay and the lowest price at which the seller is ready to sell.
Now, let’s say the gold ETF you hold has a spread of ₹0.10 because of a bid price of ₹50.10 and an ask price of ₹50.20. In this case, if you buy and then immediately sell, you lose ₹0.10 per unit. If the spread is higher, investors will have low interest, and as a result, low liquidity will impact trading efficiency.
Expense Ratio Impact
ETFs are not actively managed funds. Since they mimic the index, the portfolio is rebalanced only when there is an addition or exclusion of any stock in the benchmark index or if there is a change in its weightage.
Still, they come with an expense ratio. If you hold Gold ETFs, the expense ratio may range from 0.5% to 1%. However, if you hold a broad-based Index ETF, this ratio can be as low as 0.05%.
While the figure seems nominal, over the years, due to compounding, it can sometimes eat up lakhs from your profit amount.
Correlation with Market
The majority of investors, especially in India, use Gold ETFs as a hedging tool against inflation. The reason is that when the rupee depreciates, the value of gold spikes.
On the other hand, Index ETFs move in sync with the broader equity market. When the central government makes any announcement that results in employment creation, a favourable business environment for listed companies, and affordable borrowing in the market, you will notice a spike in the Index ETF value.
Since gold performs well during economic turmoil and index ETFs perform opposite to it, always compare the returns based on their favourable conditions.
Underlying Asset Quality
By quality, we mean checking if the Gold ETF you are investing in has the backing of physical gold of 99.5% purity and is stored in a secure vault. If not, such deviation can affect not only the price performance of the ETF but also negatively affect the investor’s interest.
When it comes to Index ETFs, the basket must accurately replicate index constituents in weight and composition. If your ETF portfolio holds derivatives instead of stocks, you may notice a different performance, especially when the market is highly volatile.
Dividend and Yield Handling
The dividend factor is valid for Index ETFs. If the fund you hold has a history of offering consistent dividends, review how they are handled. Check whether the dividend amount is distributed among fund holders or the fund manager simply reinvests it.
In case it is being distributed, it will impact the fund’s compounding potential. If it is reinvested, then even a delay of a few weeks can result in the fund underperforming the benchmark, especially in the bull phase.
Investment Mode
Whether you have invested in an ETF through a lump sum or a SIP also affects how the fund has delivered. For example, if you invest a lump sum in a Gold ETF when gold prices are down, the returns will be much better compared to the SIP mode of investment.
Index ETFs offer better returns when invested through SIPs. The reason is that the stock market is highly volatile; when the market is down, you get more units, and when it is high, fewer units, bringing down your total holding costs due to the rupee-cost averaging method.
Conclusion
Gold and Index ETFs can deliver as promised if chosen wisely. Evaluating factors like tracking accuracy, liquidity, expense ratio, market correlation, asset quality, dividend handling, and investment mode is crucial.
Gold ETFs suit hedging needs, while Index ETFs align with long-term market growth. Matching the ETF’s strengths with your goals, while keeping costs and risks in check, ensures better returns and investment satisfaction over time.