Why gold mutual funds outshine gold accumulation plans?

Buying gold jewelry was a BIG (expensive) deal for Mansi, 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 Mansi 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 Mansi, 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. We agree. 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.

Disclaimer, Statutory Details & Risk Factors:

The views expressed here in this article / video are for general information and reading purpose only and do not constitute any guidelines and recommendations on any course of action to be followed by the reader. Quantum AMC / Quantum Mutual Fund is not guaranteeing / offering / communicating any indicative yield on investments made in the scheme(s). The views are not meant to serve as a professional guide / investment advice / intended to be an offer or solicitation for the purchase or sale of any financial product or instrument or mutual fund units for the reader. The article has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. Whilst no action has been solicited based upon the information provided herein, due care has been taken to ensure that the facts are accurate and views given are fair and reasonable as on date. Readers of this article should rely on information/data arising out of their own investigations and advised to seek independent professional advice and arrive at an informed decision before making any investments. Please visit – www.quantumamc.com/disclaimer to read scheme specific risk factors.

Above article is authored by Quantum.

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