Double tracking error makes gold FoFs riskier

While investing in gold through the mutual fund route, investors are faced a dilemma: whether to invest in gold ETFs directly or take the gold fund of funds (FoF) route.

Gold FoF is a new concept that has been introduced in the market mainly to tap those investors who do not have a demat account but still want to invest and enjoy the advantages of gold ETFs.

Under this type of investing, mutual funds mobilise money from investors, and then invest the same in Gold ETFs, either in the ETF floated by the same fund house or from ETFs floated by different fund houses.

Among the advantages of gold FoFs is the ease of investing. Even if you don’t have a demat account, you can still invest in gold through this route, which also brings with it most of the advantages of gold ETFs.

The main disadvantages of investing in gold FoFs is the higher cost, also called expense in market parlance. As an investor in Gold ETFs you pay about 75-100 basis points (100 basis points = one percentage point) on the total value of your holding as annual expense. When you invest in gold fund of funds, you have to incur an extra cost, which could be as much as 75 basis points. Most of the gold FoFs charge about 1.50% as annual expense.

Another disadvantage is the double tracking error. At first, the gold ETF or the ETFs in which a gold FoF invests will have its/their own tracking error relative to the price of physical gold. Then since it's a fund of funds, it will also have its own tracking error compared to the NAV(s) of the funds in which it has invested in.

So, in effect, a gold FoF has to take care of tracking errors at two levels, which, in turn, could weigh on the returns when returns on physical gold itself is very low. In case in any year the return on physical gold is negative, the returns from gold FoF would be even lower.

So if you have a demat account, there is every possibility your financial advisor would advise you to take the gold ETF route rather than the gold FoF route.