Gold-backed ETFs and gold futures: What’s the difference?

Gold futures and gold-backed ETFs are two popular forms of dematerialized gold for investors looking to diversify their portfolio or for those who want to invest in gold without worrying about storage. In 2020, both gold futures and ETFs saw a rise in demand, with ETFs having record annual net inflows of $ 47.9 billion.

However, there are significant differences between gold futures and gold-backed ETFs in terms of liquidity, leverage, and costs – differences that could influence an investor’s decision on which instrument they would like to invest in.

Defining gold-backed ETFs and gold futures

Both gold futures and gold-backed ETFs are financial instruments traded on exchanges, but there are fundamental differences between the two.

Gold Futures: Gold futures are contracts in which a buyer agrees to purchase a specific quantity of gold at a predetermined price at an agreed date in the future. Investors seeking to redeem gold futures can do so with a cash settlement or physical delivery of gold (if mentioned in the contract).

Gold-backed ETF: Gold-backed ETFs, are commodity funds that invest in both dematerialized and paper form of gold rather than in its physical form. So, when investors redeem gold-backed ETFs, they will either receive the cash equivalent or physical gold for investors who want to redeem a minimum of 1 kg of gold

Leverage

Leverage is an investment technique of using borrowed capital to maximize potential returns on an investment. Here’s how ETFs and gold futures compare:

Gold Futures: Futures are leveraged products. The investor essentially pays a small margin and then bets on the likely direction the commodity price will move towards. This enables cash-strapped investors to use leverage – or borrowed capital – to exploit a specific opportunity in the market.
In India, margins for gold futures are around 4% of the notional value of the contract; this means investors pay only 4% of the contract’s value initially . 

Gold-backed ETFs: An ETF derives its value from holding “underlying assets”, which in this case is gold. There is no leverage when it comes to ETFs as there is no “good faith margin” involved. Some brokers may extend loans to buy ETFs, but these are similar to all types of loans with associated costs.

Costs

Both futures and ETFs allow investors who don’t want to, or cannot afford to, invest in physical gold to explore less expensive alternatives. Here are the costs associated with them: 

Gold Futures: Gold futures are straightforward in the sense that investors can buy or sell gold at their discretion, and there are no transactional costs involved. There is no management fee and no third parties making decisions on behalf of the investors, who can own the underlying gold at any time. 

However, gold futures involve broker account opening charges and brokerage commission for long-term investors who want to extend the expiration date of their original contract. If an investor decided to roll over their futures contract, that could also involve some costs.

Gold-backed ETF: Costs associated with ETFs involve demat account charges on an annual basis, brokerage charges on both buying and selling, and fund management expenses which is usually a minimal percentage of the total fund value. There could also be some “tracking errors” that could occur, which could arise due to any expenditures incurred by the fund or when some of the underlying gold is sold to cover the expenses of the fund.

Taxation

The tax rates for gold futures and gold-backed ETFs depend on the trader, the country, and the holding period.

Gold Futures: Tax structure associated with futures trading can be extremely complex to decipher. India has separate taxation norms for derivative contracts with gold as the underlying asset, which are primarily available to businesses only. Businesses can claim returns from gold derivatives to seek tax relief.

Gold-backed ETF: Taxes on any gain from the sale of gold-backed ETFs are matched with the sale of physical gold. Short-term capital gains on ETFs held for less than three years are added to the investor's income where it is taxed according to the existing slab. If they are held for longer, they will be subject to long-term capital gains at 20.8% cess. 

Pricing Volatility

Gold-backed ETFs and gold futures have different levels of pricing volatility, though several unique characteristics of the latter enhance this.

Gold Futures: Gold futures are leveraged products that aim to secure magnified returns. However, on the flip side, losses can also be magnified. Futures also have something called “rollover” where investors close their position before expiration and roll their expiring futures investments into other futures contracts with later expiration dates. This tends to affect price volatility.

Gold-backed ETFs: Compared to futures, ETFs show a lower degree of volatility. This is because gold ETFs follow the market price of gold as a commodity. The market price at this moment is relevant, not the price on some date in the future. Gold-backed ETFs essentially share the same price volatility as physical gold.

Gold-backed ETFs and gold futures both have their advantages and disadvantages. While gold futures are riskier investments, they have the potential to give much higher returns. If you understand the gold market and have been following it regularly, it is a very lucrative investment tool. Gold-backed ETFs, however, are safer tools with high liquidity. If you are just starting with gold investments, gold-backed ETFs are the instrument for you.