Where Do Gold ETFs and Gold Mutual Funds Actually Invest?

Do you know where your Gold ETF and Gold Mutual Funds invest? In physical gold, digital gold, or other forms, who manages risk and quality?

The most fundamental question an investor can ask is, “Where is my money actually going?” Let me explain in detail about where these Gold ETFs and Gold Mutual Funds actually invest your money.

Where Do Gold ETFs and Gold Mutual Funds Actually Invest?

For centuries, gold has been considered a wealth preservation or safe haven during crises and a reliable diversifier in an investment portfolio. Traditionally, this meant buying physical gold in the form of coins, bars, or jewellery. However, this age-old method comes with practical headaches:

• Security & Storage: Storing gold safely is a constant concern, often involving the recurring cost of a bank locker.
• Purity Verification: Ensuring you’re buying authentic, 24-karat gold can be difficult without expert help.
• Hidden Costs: Jewellery involves high “making charges” that are lost upon sale, diminishing investment returns.
• Liquidity Issues: Selling physical gold quickly at a fair market price can be a cumbersome process.

Refer to our latest article on how holding the Gold in physical form will be a loss for you, “Is Gold Jewellery a Good Investment? Beware 30% Hidden Loss!“.

Gold ETFs and Gold Mutual Funds were engineered to eliminate these obstacles. They provide a seamless, secure, and efficient way to invest in gold. But to truly trust them, we must first understand their internal mechanics.

The Gold ETF Structure – A Direct Claim on Physical Gold

Think of a Gold Exchange Traded Fund (ETF) as a digital receipt for real, physical gold stored in a high-security vault. When you buy a unit of a Gold ETF, you are buying a direct, albeit tiny, share of actual gold bars. The primary goal of a Gold ETF is to mirror the domestic price of gold, and it achieves this by primarily investing in one core asset.

Where the Money Goes: The Core Asset is Physical Gold Bullion

The vast majority of the money you invest in a Gold ETF goes directly into purchasing physical gold bars. This isn’t just any gold; it’s investment-grade bullion that adheres to strict international standards.

• Purity Guarantee: The gold held by these funds must have a fineness of at least 995.0 parts per thousand, which means it is 99.5% pure.
• Global Standard: The gold bars almost always conform to the London Bullion Market Association (LBMA) Good Delivery Standards. The LBMA is the global authority for precious metals, so this certification guarantees the weight, purity, and integrity of the gold.

Example in Action:

Let’s consider a well-known fund like the HDFC Gold ETF. When you invest, HDFC Mutual Fund pools your money with that of other investors and uses it to procure 99.5% pure physical gold bars. A designated custodian then stores these bars in insured, highly secure vaults. Each unit of the HDFC Gold ETF that you hold represents a direct claim on a fraction of that stored gold.

How the Investment is Valued: The Price Tag on Your Digital Gold

The Net Asset Value (NAV) of your Gold ETF unit is a precise reflection of the value of the underlying gold it holds. This valuation is a meticulous, transparent process:

1. International Benchmark: The process starts with the London Bullion Market Association (LBMA) AM fixing price, which is the global benchmark for gold, quoted in US dollars per troy ounce.
2. Conversion and Adjustment: This price is converted to Indian Rupees using the official RBI reference rate.
3. Landed Cost Calculation: To reflect the true price of gold in India, the value is further adjusted to include the “landed costs”—notional expenses like customs duty, insurance, and transportation charges that would be incurred if the gold were physically imported from London.

This ensures the ETF’s value accurately tracks the domestic price of physical gold.

The Audit Trail: Verifying the Physical Gold

To give investors complete peace of mind, regulations mandate strict oversight. SEBI requires that statutory auditors conduct a physical verification of the gold bars in the vaults twice a year. They count and inspect the gold to ensure that the physical holdings perfectly match the total ETF units that have been issued to investors. This report is submitted to the fund’s trustees, confirming that your digital investment is backed by a real, physical asset.

For Efficiency: Minor Investments in Gold-Related Instruments

While physical gold forms the bedrock (typically over 95%), Gold ETFs are permitted to invest a small portion of their assets in other instruments to manage the fund more efficiently.

• Gold Monetisation Scheme (GMS): The ETF can “deposit” some of its physical gold with a bank under the GMS. This is like a fixed deposit, where the fund earns a small amount of interest on the gold, helping to offset the fund’s operating expenses.
• Exchange Traded Commodity Derivatives (ETCDs): These are financial contracts (like gold futures) that derive their value from the price of gold. An ETF might use these to manage daily cash flows without the cumbersome process of buying or selling small quantities of physical gold bars every day.

SEBI has set firm limits on these non-physical holdings. The total exposure to all such gold-related instruments cannot exceed 50% of the fund’s assets, and the GMS specifically is capped at 20%. This ensures the fund remains overwhelmingly a direct investment in physical gold. Refer – Master Circular For Mutual Funds.

The Gold Mutual Fund Structure – The Fund of Funds (FoF) Approach

Now, let’s analyze Gold Mutual Funds. The vast majority of these operate as a “Fund of Funds” (FoF). This structure is fundamentally different from a Gold ETF in terms of its investment strategy.

A Gold Mutual Fund does not buy physical gold itself. Instead, its primary investment is the units of an existing Gold ETF.

Where the Money Goes: The Primary Asset is Another Fund

The investment strategy of a Gold FoF is simple: it acts as a feeder fund. You invest your money in the Gold Mutual Fund, and the fund manager’s job is to take that capital and invest it in a Gold ETF.

• Regulatory Requirement: According to regulations, a Fund of Funds must invest a minimum of 95% of its total assets into the units of its specified underlying fund(s).

Tracing the Money Trail: An Example

Imagine you start a Rs.5,000 monthly SIP in the SBI Gold Fund. This is a Gold FoF.

1. Your Rs.5,000 goes to the SBI Mutual Fund.
2. The fund manager of the SBI Gold Fund then takes this money and buys units of its underlying scheme, the SBI Gold ETF.
3. The SBI Gold ETF, in turn, uses this capital to purchase and hold physical gold bars in its vaults.

So, your investment journey looks like this: Your Money ? Gold Mutual Fund (FoF) ? Gold ETF ? Physical Gold Bullion. You are investing in physical gold, but through an indirect, two-layered structure designed for convenience.

Understanding the Cost of This Layered Investment

This “fund of funds” structure has a direct impact on the cost you bear as an investor. Since your money is being managed by two separate funds, you effectively pay for the expenses of both.

1. Expense Ratio of the Gold Mutual Fund (FoF): This is the fee for the fund manager who is handling your SIPs and investing in the ETF.
2. Expense Ratio of the Underlying Gold ETF: This is the fee for managing the ETF, including the cost of buying, storing, and insuring the physical gold.

This is not a flaw, but an inherent characteristic of the FoF structure. The slightly higher cost is the trade-off for the convenience of being able to invest without a Demat account and through simple SIPs.

To summarize the investment strategies:

• Gold ETFs invest your money directly into physical gold bullion of 99.5% purity, which is stored in secure vaults. Your ETF unit is a direct digital representation of that physical gold. A small portion may be allocated to gold-related schemes for efficiency.
• Gold Mutual Funds (FoFs) invest your money into the units of a Gold ETF. It is an indirect method of investing, where the fund you buy, in turn, buys another fund that holds the physical gold.

Both avenues ultimately lead to an investment in the same underlying asset: gold. The difference lies entirely in the path your money takes to get there. By understanding these mechanics, you are no longer just a passive investor; you are an informed participant who knows precisely where your money is, how it’s being managed, and why it is a valuable part of your financial future.

Read all our Gold-related articles HERE – Gold Archives.