Beware The New “Silver ETF”

by on July 19, 2010 | ETFs Mentioned:

No corner of the ETF market has grown as quickly in recent years as exchange-traded commodities, as investors have embraced cheap and efficient exposure to an asset class that has historically been out-of-reach for all but the biggest and most sophisticated. Perhaps due to the uncertain economic environment, precious metals funds have become particularly popular, offering a safe haven for those concerned about the strength on the current recovery. While some ETPs offer exposure to gold and silver through futures-backed funds, most investors prefer physically-backed ETFs that will generally move in lock step with spot commodity prices.

There is no shortage of ETF products utilizing this strategy, both in the gold ETF and silver ETF space. In coming months, investors may see another option out there designed with a unique sparkle designed to catch their eye. But before jumping in to a “new and improved” precious metals ETF, they would benefit from doing a little homework [also read The Definitive Silver ETF Guide].

Sprott Inc. has filed a preliminary prospectus with both the SEC and SEDAR (Canada’s equivalent of the SEC) for the Sprott Physical Silver Trust, a fund that Dorothy Kosich notes will be “aimed at giving investors the liquidity of an ETF combined with silver bullion exposure.” At first, the new product from Sprott sounds an awful lot like SLV or SIVR, the existing silver ETF products offered by iShares and ETF Securities. According to the prospectus, the trust is designed “to invest and hold substantially all of its assets in physical silver bullion,” seeking to “provide a secure, convenient and exchange-traded investment alternative for investors interested in holding physical silver bullion without the inconvenience that is typical of a direct investment in physical silver bullion.”

It gets better from there. The prospectus for the proposed silver product goes on to outline that investors will be able to redeem units for physical silver bullion on a monthly basis and will provide potential tax advantages for certain investors. That second element may sound particularly appealing; currently silver and gold are subject to taxation as “collectibles,” meaning that the effective rate can be significantly higher than the long-term capital gains tax of 15% [also see How Emerging Market ETFs Offer A New Way To Invest In Commodities].

If all of that sounds too good to be true, that’s because it probably is. Earlier this year Sprott launched its Physical Gold Trust (PHYS), a product that boasted many of the same benefits of the proposed silver trust. By most measures, PHYS has been a phenomenal success; it holds almost 600,000 ounces of gold and total assets are currently hovering around $700 million.

But PHYS certainly won’t be confused for GLD or IAU. According to the fund’s web site, PHYS currently trades at a premium of about 12% to its NAV. During the second quarter, that premium has ranged from 6% to 23%, meaning that the gold trust has exhibited significantly more volatility than spot gold prices. Moreover, returns to investors may depend more heavily on their timing of the NAV premium than the price of gold bullion. Suddenly the ability to redeem outstanding units for physical bullion at a price equal to NAV loses a bit of its luster (for the record, ETFdb didn’t immediately see through PHYS; the folks at IU did a nice piece explaining all the nuances, including why the potential tax benefits will be a mirage to most investors).

For investors looking for a way to establish exposure to silver prices, ETFs remain (and will continue to remain) the most attractive options. The new silver product from Sprott may have some characteristics of an ETF, but will more closely resemble a closed-end fund where it counts. By sticking to SLV or SIVR, investors will steer clear of the premium/discount issue and can even save a few basis points on the expense ratio [also read Three ETFs To Play Jim Rogers' Advice].

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Disclosure: No positions at time of writing.