Combination of gold and liquid fund will let you have your cake and eat it too

Gold has been in the news lately.

Prices are close to all-time highs in both dollar and rupee terms: international prices are above $1,200 an ounce, and domestic prices are approaching Rs 18,000 per 10 grams.

The high prices have not deterred investors — the holdings of New York-listed SPDR Gold Trust, the world’s largest gold exchange-traded fund, touched a record high of over 1,192 tonnes on May 10.

For perspective, that’s close to double the gold holdings of the Reserve Bank of India (which itself bought 200 tonnes of gold from the IMF in November 2009 at the cost of Rs 30,000 crore). John Paulson, the famous investor who made billions by correctly predicting the US subprime crisis, recently started a hedge fund focused exclusively on gold.

So why is the smart money betting that gold prices could go even higher? The answer lies in the many different aspects of gold as an investment.

- Gold is a scarce commodity and a luxury good. Strong economic growth in India and other important consuming nations has buoyed demand for jewellery. Simultaneously, supply has been stagnating, constrained by falling production from new mines

- Gold is an inflation hedge, a store of value whose purchasing power will not diminish even if governments are forced to debase their currencies by printing money to bail out banks or indebted borrowers. The purchasing power of a kilo of gold has stayed fairly constant over decades despite steady inflation

- When markets are seized by panic and equity markets crash, investors flock to gold as the ultimate safe-haven asset because it carries no risk of credit default.

These advantages have long been known to Indian investors. India consistently ranks as one of the world’s largest importers and consumers of gold, and international prices are strongly influenced by the Indian festival and wedding seasons, when retail demand for gold and gold jewellery rises.

However, despite the many excellent reasons for buying gold, some sceptical investors stay away from it because it does not generate a steady income stream.

In this respect, gold differs from stocks (which bear dividends), bonds or fixed deposits (which generate interest income) and real estate (which can be rented out). All traditional forms of gold investing — via coins or jewellery, ETFs and gold futures — suffer from this drawback.

If a strategy could be specifically designed to overcome this drawback while simultaneously reaping the rewards of investing in gold, we would have the proverbial option to ‘Have your cake and eat it too’.

So the way out is to form a portfolio and invest in a combination of gold exchange-traded funds (ETFs) and the dividend option of a liquid fund which invests in short-term debt.

The debt portion of the portfolio would have to be administered to generate a steady stream of interest income with a low level of risk. And that can be accomplished by investing in the dividend option of a liquid fund.

Such an accrual strategy is particularly attractive in an environment where interest rates are low but expected to rise — precisely the environment prevalent in India today.

The RBI has acted twice this year already to tighten monetary policy, and is expected to adhere to a tightening course going forward. In such an environment, holding longer-term bonds exposes the investor to duration risk, the risk that interest rates will go up causing existing bond holdings to decline in price. By holding short-term instruments, the accrual strategy would explicitly avoid duration risk. Also, by investing only in safe, highly rated instruments, it would minimise the credit risk of its portfolio.

To sum up, a risk-averse investor looking for a steady stream of income with an added bonus of capital appreciation would be well served by this strategy.

The writer is head - fixed income, Canara Robeco Mutual Fund