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ETFs: Some interesting facts

June 25, 2007 12:11 IST

The Securities and Exchange Board of India has proposed to allow mutual funds to launch exchange traded funds. ETFs are to be available for trading on stock Exchanges.

Funds collected by the mutual fund will be invested in gold and hence the net asset value of the ETF will be largely dependent upon price of gold minus the administrative costs of the AMC and the mutual fund.

Legal meaning of Gold ETF:

By design, such ETFs are based on an underlying commodity, which is Gold. Gold is a commodity notified under Section 15 of the Forward contracts Regulation Act, 1952. It implies that forward contracts in gold can be conducted only by or through members of associations (read Exchanges) recognized by FMC. Since trading in ETF, where the underlying asset is gold, is a type of forward contract, because the delivery of gold is deferred for a future date, it can be conducted only by the members of associations recognized by FMC.

Gold has been covered under the Sebi (Mutual Fund) amendment Regulations, 2006 enabling mutual funds to invest, keep custody and also trade in gold. But, the term "securities" as defined under Securities Contracts Regulation Act does not cover gold. The regulation cannot supersede the basic provisions of SCRA and FCRA.

Hence, the only feasible way to launch Gold ETF is to allow its trading and settlement through recognized Commodity Exchanges with due permission of FMC.

Operational Issues:

At present, mutual funds are not allowed to trade in commodity exchanges. So, if gold price crashes, Gold ETF units will also crash, as mutual fund is not allowed to hedge its position on a commodity exchange. Since there is no internal accruals to gold like dividend, right, bonus, etc., on the contrary there is a recurring cost in terms of storage cost, vaulting, insurance, security arrangement, etc, it is still a question mark, how the mutual funds will service the investors. The net return arising out of appreciation, if any, in the price of gold over a long period of time minus the administrative cost of the AMC and the mutual fund,
may often be negative.

This project will need AMCs to acquire expertise in buying and selling gold in the physical market as well as safe storage of gold with security arrangements. Whenever they issue new units or whenever they redeem some units, buying or selling of gold is to be done. Buying of gold from the physical market has a number of problems like purity of gold, identifying exact carets, etc. AMCs may not have expertise to do that.

At the time of buying, they must be careful about its source, because gold trade is often affected by issues relating to impurities as well as money laundering or smuggling of gold, which attracts Foreign Exchange Management Act violations.

If gold lying in possession of such mutual fund is tracked back to some hawala or money laundering or smuggling activities, it may create a big problem for the fund.

Similarly, for sale of physical gold, there is no structured physical market. If a mutual fund has to sell gold worth Rs 100 crores (Rs 1 billion), what would be the process to ensure transparency and immunity from settlement defaults? Banks or other Govt. agencies only sell gold, they do not buy. Since export of gold is banned, mutual fund cannot export it for sale overseas.

Vaulting of gold is also an issue, because of high risks attached to it. If they keep gold with some custodian or bank, it is difficult to keep a check and control to ensure that the custodian does not sell that gold in the market. If we take adequate bank guarantee from the custodian equivalent to the value of gold lying with them, it would add to cost and the project would become unviable.

The valuation methodology adopted by the mutual fund is based on international gold price, discovered in LBMA, as per AM/ PM fixing. But, when the AMC will buy or sell gold, they have to do it in Indian bullion market. Our prices are sometimes at a premium and sometimes at a discount to international spot prices.

Therefore, the units valuation based on international spot price may not be a true reflection of valuation of assets.

The entire mechanism of Gold ETF is based on successful functioning of Authorized participants. Authorized participant is supposed to buy gold out of his own funds, deliver such gold to custodian, get equivalent units from the mutual fund, provide two way quote on NSE for the units, take all the headache of liquidating physical gold when he wants to convert his unit holding in cash. It would be a tough task to find such authorised participant willing to assume all such responsibilities.

At present, volatility in commodity prices, price movement in spot market, price movement in futures market, international reference prices, etc. are monitored by FMC and the Commodity Exchanges. If there is any distortion in basis ( difference between spot and future), then the Exchanges and FMC take immediate action by way of monitoring position of the traders, increasing margin, etc. Once Gold ETF is launched, it would add another dimension to it. FMC and the Commodity Exchanges would not be able to monitor, if some body tries to jack up the price by buying ETF units.

Sales Tax compliance:

On a careful scrutiny of the system being proposed under Gold ETF, it is evident that the sale of units by a mutual fund to investors can have either of the following connotations:

  • Either it is sale of unit based on prevailing price of gold, where unit is a derivative of gold, as it derives its value from prevailing price of gold. If we go by this definition, it becomes a forward contract in gold, which must be regulated by FMC, otherwise it becomes illegal.
  • Alternatively, it is an instrument through which the mutual fund is selling gold to the investor on the date of investment against payment and after that mutual fund is providing custodian facility for safe upkeep of gold belonging to such investors. If we follow this definition, Gold ETF goes outside the purview of FMC, as it becomes a ready delivery contract.

But, unfortunately in this case, the nature of transaction will be that of sale of gold by mutual fund to the investors as the ownership rights are being transferred by the fund to the investor and therefore, it would attract sales tax compliance. The mutual fund may obtain sales tax registration to comply with sales tax laws, but the problem arises when the investors want to sell units back, either to the mutual fund for liquidation purpose or by way of sale to other investors through stock exchange.

In case of any such transfer or sale, the investor should also have sales tax registration and he has to file proper returns also every quarter with local sales tax authorities. If an investor is not registered with sales tax authorities, it becomes  URD (unregistered dealer) sale, when such investor sells to another person, which attracts sales tax every time.

Since sales tax is a state subject and there are different state sales tax laws in different states, we should be careful about compliance with all such provisions. Investors' perspective: Investor will be net gainer only if gold appreciates between the date of buying and selling minus the load on account of expenses and AMC costs. If the price remains constant or depreciates, he will be net looser.

The basic expertise of AMC, which ensures value creation for the investors, lies with active management of assets and churning out portfolio in accordance with market dynamics. But, in the proposed Gold ETF, mutual funds would be doing passive management only.

We can understand the investors' perspective from the following example:

  • An investor invests money in Gold on February 1 2007 and liquidates investment on 1st February
  • Price of Gold is Rs 9,000 per 10 grams on February 1 2007 and Rs 9,900 per 10 grams on 
    February 1 2008.
  • Cost of money and brokerage to execute trades is same in all the three options.
  • He buys Gold ETF worth Rs 1 lacs on 1.2.07 and sells all units on 1.2.08.
  • His net return would be approximately Rs 5,000 (Rs 10,000 as 10 per cent return on Rs 100,000 as gold has appreciated by 10 per cent minus AMC cost of Rs 5,000 being 5 per cent of Rs 100,000).
  • He buys physical gold bar / coin worth Rs 100,000, keeps in his locker and sells it on 1.2.08.
  • His net return would be Rs 10,000, as the cost of storage, vaulting, etc. will be zero.
  • He buys futures contracts worth Rs 10 lacs (Rs 1 million) after paying a margin of 10 per cent, that is Rs 100,000, rolls over his position after every two months and sells futures position on 1.2.08
  • His net return would be Rs 100,000 -- roll over cost( around 7 per cent of Rs 10 lacs for 1 year, that is Rs 70,000), which means a net return of Rs 30,000.

Hence, buying gold futures is the best option. In India, trading in gold related instrument is already being conducted under the aegis of MCX. Incidentally, MCX is the third largest exchange in world for gold futures, doing a daily business of 30-40 MT of gold worth Rs 3-4 thousand crores (Rs 3 to 4 trillion). It has handled delivery of gold worth more than Rs 100 crores in single contract.

Economic Rationale:

Gold is considered to be a dead investment. Money parked in gold is actually not used in economic growth; rather it goes out of the system. When investors invest money in shares, the companies use that fund for setting up industries, which contributes towards economic growth and employment. If the investors shift their investment from stocks to gold, that could be detrimental to economic development.

Gold ETF is a devise to divert peoples' savings towards gold. Whether it is desirable for the country's economy or not, is still a question mark.

In the interests of law as well as in the larger interest of investors, the ideal solution is that Gold ETF should be traded on commodity exchanges, while mutual funds willing to raise funds from the public should be regulated by SEBI. After raising funds, mutual funds should use such funds for buying and selling gold futures on commodity exchanges. For this purpose, Sebi should allow the mutual funds to trade on commodity exchanges at least in gold futures. In this case, there would be enough flexibility available with AMCs to show their trading skill through active management of portfolio.

Commodity Online Special