Monday, December 27, 2010

Talking about Gold and Silver - Part 4

If you ignore ornaments, there are three ways you can buy gold. Physical gold in the form of gold biscuits, electronic gold in the form of ETF’s, and electronic gold in the form of e-gold from the commodity exchange. When it comes to silver, ETF’s have not yet been allowed by SEBI, and hence the options are only two – physical bars, and e-silver from the commodity exchange. Each of the modes of holding has its own characteristics.


Bullion in the physical form is the most free from political control.  In the US it was not lawful for private citizens to hold gold for a long time, and in India till the mid-90's, gold imports were restricted in order to curb private holdings of the metal.  In situations of war or public emergency , the entire gold reserves of the country can be commandeered by the government, who can pay you cash in return. But one of the reasons why we hold gold and silver is as a hedge against the threat of currencies becoming worthless! Gold in ETF form or gold lying in the commodity exchanges are easiest for the government to lay its hands on.  Also, in a situation where the actual physical stock is with someone else, and all that you hold is a piece of paper “promising” you delivery, there is always a counter-party risk involved. This risk could play out in various ways. For example, how do you know that the ETF is actually holding physical gold – part of their portfolio could be in the form of “gold-backed” securities which, unbeknownst to them, may not have a backing of solid gold behind it?


Modern markets and institutional structures with the backing of relevant laws and regulators, are built in such a way that they give us the confidence to trust in them. I do. I do trust them to the extent that a major portion of  my assets are lying with the government as PF or PPF, or in the stock markets as shares in demat form. But the 10 to 15% percent that I put aside as the “ultimate fall back”, – my investment in gold and silver serves this purpose apart from being a good investment on its own merits  – I would like to keep in physical form in my custody, thank you very much. Guarding against Black Swan events at least to the extent of 1/6th of my holdings strikes me as a sensible thing to do.


Okay, so let’s not get paranoid. Let us bring the debate back to level ground where there are no armageddons, no apocalypses. Assuming all the modes of holding are equally safe, how do we decide in what form to hold gold and silver?


We examined physical bullion in the last part of this series. When you sell gold biscuits or silver bars, the tax treatment is the same as that for any other asset. If you have held it for less than three years, the profit on sale would be added to your income for this financial year, and you will end up paying full tax calculated at your marginal rate. If you have held it for more than three years, you will be taxed  at  rates pertaining to long-term capital gains, i.e., 20 percent after indexation benefit, which could work out to anywhere between  13   and 20 percent of the gains. Having said that, most transactions in physical gold and silver are in cash, and carried out at the retail level.


You can buy gold (not silver, not yet at least) in ETF form. ETF’s are nothing but “Exchange Traded Funds” which are closed-ended mutual funds that are “traded” on the exchange, i.e., units of the fund are bought and sold on the exchange just like shares at the day’s quoted price, rather than redeemed through the fund manager at the day’s NAV. Gold ETF’s invest in gold and hence their prices are supposed to closely track the price of gold. For this, they charge a management fee which  in India  varies from 1% to 1.5% percent per annum. If one tracks the last few years’ performance of gold ETF’s , it has been observed that they do not exactly give the same return as the price of gold; they actually lag the gold price increase by about a percent every year. Part of this is of course due to the management fee that is charged for managing the fund. There are about a dozen Gold ETF’s in the Indian market – among them I prefer Goldbees from Benchmark AMC.


Buying from the cheapest retail source entails a buy/sell spread of about 4%, as we saw in the previous part. Add about 2% for the extra hassle of keeping physical gold, and selling it when the time comes, and you get, say, 6%. Buying an ETF through a broker involves commission at the time of buying and selling, totaling to about 1.5%. Add to this a management fee of, say, one percent per year. Equating the two, you get a “break-even” period of about five years. If your investment horizon is less than five years, go for ETF. If it is more than five years, you should prefer physical gold.


Gold  ETF’s get a special tax treatment since they have been classified as “ non-equity mutual fund ”.  If you hold ETF’s for more than a year, any gains you make on sale classifies as “long-term” and you can pay tax at the rate of 10 percent of the gains In case you hold it for less than a year, the gains are just added to your income and taxed at your marginal rate. This compares very favorably with physical gold, where the threshold for considering it long-term is three years.


You can also hold gold and silver in “e” form. National Spot Exchange, which is a commodity exchange, offers “e-gold’ and ‘e-silver’. They are like demat shares – you hold them in a separate commodity demat account that you open with them. They are fully backed by physical gold/silver with a facility to deliver the bullion physically to you at a nominal cost, at your option. You buy or sell them like you do shares. The tax treatment is the same as for physical gold or silver. Visit the website of National Spot Exchange to find out the modalities of opening an account, etc.


That concludes our four-part series on gold and silver. If you have been just reading this, and not bought any, it is time you ventured out into the market and bought some!


Narri said...

Very informative, quick question - how about taxation of gold in it's natural form or jewelry ? Since that's very difficult to trace ...

Dinesh Gopalan said...

Tough luck Narri - jewelry is taxable - don't of any one yet who actually paid though...

extracts from the IT Act..

According to Income Tax Act,1961 there are few assets which don't form a part of Capital Assets, which are as follows:
Stock of goods and raw materials ---
Those property which are movable like wearing apparel, furniture, automobile, phone, household goods etc. Held by assessee. But Jewelry which is also an movable assets comes under heads of Capital Assets
---Agricultural property in India. ---
Few Gold Bonds issued by government
--- Few special bonds issued by central government like Special Bearer Bonds, 1991

The Wretched Anglophile said...

Excellent piece, Dinesh. Just a quick question - if I am to buy physical silver from a jeweller's in Bangalore, how do I assure myself of the quality/purity?


Anonymous said...

Can we get loan on the basis of ETF units? Like Muthoot gives on physical gold, is it so for ETF too?

Dinesh Gopalan said...

'Anglophile' right now I go with references. The big-name retailers will give you good quality but they are too expensive. Your best bet for good quality at the right prices is to get a reference to someone who operates in the Jewelry market which is in and around Avenue Road. I know that physical testing is also possible, but I have never found out how and where to do that.

'Anonymous' - banks offer loans on the basis of ETF units just like they do on shares. It will come under the "loans against shares" scheme and is a fairly simple and straightforward process.