Explaining The Wacky Discounts For The Silver ETF (SLV)

by on November 11, 2010 | ETFs Mentioned:

Although gold’s seemingly unstoppable rally has been one of the dominant stories of the last several months in the financial world, it is another precious metal that has stolen the show from a performance perspective. Silver has quietly emerged as one of the best-performing asset classes of 2010; the year-to-date gain of more than 60% more than doubles gold’s impressive climb [see Seven Reasons Why Silver Could Soar].

But silver finally hit a speed bump this week, not in the form of renewed confidence in the greenback or dip in industrial demand, but from an unexpected change to margin requirements by the CME’s Comex unit. Late on Tuesday, the exchange announced that it was increasing the margin requirement for trading silver to $6,500 per contract from $5,000. The move by the CME proved to be the first of several revisions to margin requirements, as the minimum amount that must be ponied up by traders was increased for soybeans and cotton as well.

The development clearly spooked investors, and sent silver into a freefall. It also caused what may appear to be erratic behavior from exchange-traded funds (ETF) that offer exposure to silver prices. The iShares Silver Trust (SLV) is the largest U.S.-listed physically-backed silver ETF, with more than $9 billion in assets (or about 344 million ounces of the precious metal). Because the underlying holdings of SLV are bars of silver bullion, the fund will generally move in lock step with spot silver prices. So it may have come as a shock when SLV lost more than 3.5% on Tuesday and closed at a discount to its NAV of 6.23%, according to the iShares Web site. On Wednesday, silver prices on the Comex plunged more than 7%, but SLV actually gained more than 2% on the day [also read The Ten Commandments Of ETF Investing].

As most investors know, there are arbitrage mechanisms in place under the hood of ETFs to prevent share prices from deviating significantly from the NAV. So what in the world could be driving the huge disconnects between prices of SLV–one of the most liquid ETFs in the world–and the net asset value? Another ETF flaw for Kaufman or Bogan to sink their teeth into?

Not exactly. There’s a rather simple explanation, and it all has to do with timing.

Silver Exchange

The silver market is rather unique. The largest silver futures exchanges are the COMEX and Tokyo Commodity Exchange, while the OTC silver market operates 24 hours per day with centers in London, New York, and Zurich. As such, there are several different ways for determining the price of futures:

  • New York Standard: During regular COMEX trading hours, the price at which each silver contract trades is immediately disseminated around the world–much like traditional equity markets.
  • COMEX Pricing: After the close of each trading day, a committee of COMEX members meets to determine the daily settlement price for each silver contract; the settlement price for the most active month is the average of the highest and lowest prices for that month reported during the last one minute of trading.
  • London Fix: The London Bullion Market Association (LBMA) fixes the London spot price of silver twice daily (once in the morning and once in the evening). Formal participants in the London Fix–traditionally limited to five members–are bullion dealers.

SLV uses the London Fix for calculating its daily net asset value, which is the reason for the appearance of wacky discounts recently.

SLV actually started Tuesday trading on a strong note, and was in positive territory well into afternoon trading. Once news of the stricter margin requirements broke, however, shares plummeted, and SLV lost more than 8% in the final three hours of trading (including a 4% dip in the last hour of the day). So when the discount for SLV was calculated for Tuesday, the share price of the ETF reflected all current information–including the news of the new margin requirements. The NAV figure, however, was already stale, and didn’t take into account news of the rules change. So the negative news wasn’t reflected in most measures of silver’s price until Wednesday. “Open outcry” trading of silver futures on the COMEX, for example, ended at 1:25 ET–before news of the higher margin requirements broke. But trading in SLV was still open at that point, and many investors turned to silver ETFs to trade on the latest developments [also read Playing Precious Metals Through Equity ETFs].

In other words, the big discount wasn’t the result of an inefficient market, but rather the nuances of the NAV calculation. SLV’s price was indicative of the market price of silver on Tuesday–the figure used for the NAV was not.

Premiums Too

A similar scenario played out last month in the corn market. On October 8, the USDA released a report indicating that revised projections for this year’s corn harvest considerably lower. The news came as a shock to traders, and corn prices immediately jumped by the maximum daily allowable amount (about 6%), effectively ending trading for the day even though investors believed that the unexpected development warranted a much higher increase in price.

Enter the Teucrium Corn Fund (CORN), an exchange-traded product that invests in corn futures. Investors snapped up shares of CORN, which rose more than 14% on the day. Because the NAV had been prevented from climbing above a certain threshold–at the time futures couldn’t add more than 30 cents per day–the fund finished the week at a premium of more than 8% to its NAV. Again, the price of the fund was reflective of the current market, while the NAV was not. The result may have raised some red flags, but in reality the ETF was as liquid as ever [see Explaining The Corn ETF's Huge Premium].

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Disclosure: No positions at time of writing.