(Mike Maharrey, Money Metals News Service) In what seems like a groundbreaking move, an Indian gold ETF is set to back its fund with gold futures contracts, as well as physical metal.
ETF is an acronym for “Exchange Traded Fund.” In simplest terms, an ETF represents a basket of investments that trades on the market as a single entity. An ETF can represent just one commodity, such as oil, or a fund can hold a wide range of assets, such as tech stocks.
Like stocks, ETFs are sold in shares. The price rises and falls throughout the trading day as they are bought and sold on the market, just like a stock or bond.
A gold ETF is backed by a trust company that holds metal owned and stored by the trust. In most cases, investing in an ETF does not entitle you to any amount of physical gold. You own a share of the ETF, not gold itself.
Under Indian regulations, ETFs must maintain a 95 percent allocation to physical gold and related instruments.
Sebi opened the door to including gold futures contracts as part of that allocation in June 2024. HDFC Gold ETF announced plans to take advantage of this provision via a notice-cum-addendum dated March 15.
This seems obvious, but it’s important to emphasize that a futures contract is not the same as gold. In practice, buyers commit to purchasing gold at contract expiration, while sellers commit to delivering it.
Futures contracts trade on the open market, oftentimes with no actual delivery of physical silver. Contracts can be rolled over indefinitely. However, if the buyer in the contract opts for delivery, the seller is obligated to provide the requisite amount of gold on the delivery date. If the current price is above the contract price, the seller “wins” and takes a profit. If the spot price has dropped below the contract, the buyer takes the gain.
There is nothing inherently wrong with futures contracts. They allow gold buyers and sellers to hedge price movements. However, futures trading is extremely speculative.
There is also a significant risk because there are vastly more futures contracts than physical metal.
It’s similar to fractional reserve banking. As long as everybody is content to keep their money in the bank, the system hums along quietly. But when people lose faith in the bank and demand their dollars, you end up with bank runs. Similarly, if enough people demand physical gold instead of rolling contracts, the paper system could collapse.
According to The Times of India,
“Experts maintain this is not a structural shift to ‘paper gold’ but a liquidity or backup mechanism. Think of ETCDs (Exchange Traded Commodity Derivatives) as a shock absorber, not a replacement for physical gold. Gold ETFs are still required to primarily reflect gold prices.”
However, as already noted, owning an ETF is not the same as owning physical metal. It is paper gold in and of itself. You own a piece of paper backed by gold that may or may not exist. (It probably does, but you can’t touch or see it.) Allowing ETFs to add gold futures contracts to the mix moves these investments even further away from gold itself.
Wise Finserv CEO & CIO Ajay Kumar Yadav downplayed the move.
“Giving fund managers the option to use gold futures is really about handling practical situations better,” he told the Economic Times of India. He explained,
“If there are sudden inflows or a temporary delay in buying physical gold, the gold ETF doesn’t have to sit on cash. It can use futures to stay aligned with gold prices. That can help in reducing small inefficiencies, which investors usually don’t notice but do matter in the background.”
Yadav conceded that rolling over futures contracts adds transaction costs that could dent ETF returns.
But there is a more fundamental problem with allowing futures contracts to back gold ETFs. It introduces additional counterparty risk. There is always the possibility that either party could default on a futures contract.
Not everybody is thrilled with the rules allowing futures to back gold ETFs. Independent consultant Balakrishnan R. told The Times of India that it fundamentally alters the construct of the gold ETF.
“We buy the ETF for passive exposure to gold, so why introduce an active element to it? You don’t change the rules of the game after you invite the participants.”
Quantum Mutual Fund CIO Chirag Mehta agreed.
“Our belief is once you change the underlying holding from physical gold to any other, it changes characteristics, bringing different nuances to consider.”
He warned that “any disruptions in physical gold supply will reflect in market prices and get captured in the ETF’s net asset value (NAV).”
He also pointed out that gold ETFs are required to purchase gold that conforms to LBMA standards.
“The underlying in gold futures may not always conform to this, which can be a problem when taking delivery.”
Mike Maharrey is a journalist and market analyst for Money Metals with over a decade of experience in precious metals. He holds a BS in accounting from the University of Kentucky and a BA in journalism from the University of South Florida.
