Your Questions Answered: What is the difference between SGBs and gold mutual funds?

Q. I am a retired government professor, and my wife is a retired Indian Forest Officer, and both of us receive pensions from the government. We have been investing in physical gold for many years, we generally buy gold once a year at Dhanteras. However, this year we intend not to buy physical gold this year but one of its digital alternatives. Most of our acquaintances have suggested that we either invest in sovereign gold bonds or gold mutual funds. Can you please elaborate on the differences between the two and especially the difference between the taxation of the two asset classes?

Padmanabhan Iyengar, Coimbatore, Tamil Nadu 

In the dynamic landscape of the Indian securities market, gold has long held its position as a coveted asset, offering a hedge against inflation and economic uncertainty. However, when it comes to investing in gold, investors often face a dilemma between two popular options: gold mutual funds and sovereign gold bonds. Understanding the nuances of each instrument is crucial for making an informed decision that aligns with one's investment goals and risk tolerance.

Working mechanism: Demystifying the processes

Gold mutual funds and sovereign gold bonds differ fundamentally in their operational structure. Gold mutual funds invest in physical gold or gold-related securities, such as gold ETFs. The fund manager actively manages the portfolio, aiming to capture the price movements of gold. In contrast, SGBs are debt securities issued by the Reserve Bank of India (RBI) on behalf of the Government of India. The value of these bonds is directly linked to the price of gold, additionally, investors receive a fixed interest rate of 2.5% per annum.

Understanding gold mutual funds

Gold mutual funds are investment instruments that pool funds from multiple investors to purchase gold bullion or gold-related securities. These funds track the price of gold, offering investors exposure to the yellow metal without the hassle of physical storage and security concerns.

Key features of gold mutual funds:

Investment horizon: Gold mutual funds typically have a flexible investment horizon, allowing investors to enter and exit the fund at their convenience.

Returns: Returns are primarily linked to the performance of gold prices. Capital gains from gold mutual funds are taxable as per the investor's tax slab.

Risk profile: Gold mutual funds are considered relatively low-risk investments, as they are less volatile than equity or debt instruments.

Sovereign gold bonds: A government-backed option

Sovereign gold bonds (SGBs) are government-backed securities that offer investors exposure to gold prices while providing a fixed interest rate. These bonds are issued by the Reserve Bank of India and are considered a safe and secure investment option.

Key features of Sovereign Gold Bonds:

Investment horizon: SGBs have a fixed tenure of eight years, with an option for early redemption after five years. However, you can sell your SGBs in the secondary market to third parties at any point of time. 

Returns: Investors receive a fixed interest rate of 2.5% per annum, payable semi-annually, in addition to capital appreciation based on gold prices. Capital gains from SGBs are tax-exempt if held till maturity.

Risk profile: SGBs carry minimal risk as they are backed by the government and are guaranteed to provide a fixed interest rate.

Key differences between SGBs and gold mutual funds 

Returns: The returns from gold mutual funds and sovereign gold bonds are influenced by different factors. Gold mutual funds aim to track the price of gold, but their performance may fluctuate depending on the fund manager's expertise and the overall market conditions. Sovereign gold bonds, on the other hand, track the price of gold more precisely and additionally offer interest at the rate of 2.5% per annum.

Lock-in period:  Gold mutual funds typically do not have a lock-in period, allowing investors to redeem their units at any time. However, early redemptions may attract exit charges. Sovereign gold bonds have a fixed lock-in period of eight years, but investors can exit after five years through a sovereign gold bond liquidity window. Additionally, you can sell your SGBs in the secondary market to third parties at any point of time. 

Risk profile:  Gold mutual funds and SGBs both can be considered low risk since their performance is tied to the value of gold to a large extent. However, in the case of gold mutual funds the fund's performance may be affected by the fund manager's decisions to a limited extent. Additionally, SGBs are considered especially low-risk investments as they are backed by the Government of India.

Taxation: After the budget of 2023, capital gains resulting from the sale of gold mutual funds are added to the investor’s income and thereafter taxed as per the income tax slab applicable to the investor. On the other hand, SGB offers tax benefits as the capital gains on redemption after eight years are tax-exempt. The interest earned on sovereign gold bonds is taxable as per the investor's tax slab.

Frequency of returns: In the case of gold mutual funds, you will receive returns when you decide to sell them. The quantum of the return will depend on the rise in the price of gold majorly. Sovereign gold bonds provide fixed interest payments on a semi-annual basis and at the end of the 8-year period you will be able to redeem your investment and the quantum of your return will depend on the appreciation in the price of gold. 

In conclusion, the choice between gold mutual funds and sovereign gold bonds depends on an investor's investment goals, risk tolerance, and time horizon. For investors seeking growth potential and active portfolio management, gold mutual funds may be suitable. For those prioritising capital preservation, guaranteed returns, and tax benefits, sovereign gold bonds offer a compelling option. 

Ultimately, the decision to invest in gold mutual funds or sovereign gold bonds should be made after careful consideration of one's financial situation and investment objectives. Consulting with a financial advisor can provide valuable insights and guidance in navigating the complexities of gold investments.

Kuvera is a free direct mutual fund investing platform.

Note: This is for informational purposes. Please speak to a financial advisor for detailed solutions to your questions.