ETFs To Play White Hot Silver

by on November 12, 2010 | ETFs Mentioned:

One of the recurring investment themes over the last several months has been the seemingly unstoppable climb of gold. As the U.S. dollar has encountered weakness driven by worries over inflation and deteriorating credit quality, investors have embraced hard currencies as a hedge against the greenback, sending prices of gold bullion skyrocketing. The precious metals rally was given another boost last week with the unveiling of QE2, the latest capital injection program from the Fed that many investors believe will weigh on the dollar and stoke the inflationary flames.

While gold’s remarkable rally has dominated the headlines, the performance has been overshadowed by another precious metal. Silver has quietly emerged as one of the top-performing asset classes of 2010, thanks to many of the same factors that have driven gold prices higher. Silver has climbed by more than 60% so far in 2010, more than doubling the run-up in gold prices of about 28% since the start of the year. Silver was recently trading at its highest level in more than 20 years, and the silver/gold ratio had fallen to about 50.

While this does represent a significant decline in the ratio, it is important to remember that for hundreds of years the ratio was set at 15:1 and the ratio maintained an average of 1:47 during the 20th century. This suggests that silver is finally catching up to historic averages when compared to its pricier and more famous cousin and that it may have even further to go. Yet, this surge in prices goes beyond reversions to historical means. Unlike gold, silver has a variety of practical industrial applications across a variety of industries. Besides uses in jewelry and coins, silver is an effective conductor that is used in everything from film to dentistry to musical instruments. The metal also represents a much more effective and accessible play on inflation thanks to its extremely low price which ensures that virtually any investor in the world can afford to purchase a few coins in order to protect their portfolios from the ravages of inflation.

Investors have also been increasing their exposure to the metal not only as an axillary play on a variety of high growth sectors such as solar power, but to protect against rising volatility in the markets. Debt concerns are once again creeping into the picture among the perpeherial nations in euro zone while the yen and dollar are not doing much better thanks to high debt loads and flat economies. This really leaves only one option for investors; precious metals, which is why we have seen such incredible gains in the value of the group over the past few months [also see Seven Reasons Why Silver Could Soar].

Brief Detour?

Silver’s impressive rally was momentarily derailed this week, as an unexpected change in margin requirements sent prices tumbling in Wednesday trading. In response to surging prices and higher volatility, the CME Group recently raised the minimum maintenance margin for silver to $6,500 from $5,000 per contract–meaning that investors must now pony up more money to trade and hold a silver futures contract [see Explaining The Wacky Silver ETF Discounts].

The rise of the ETF industry has significantly expanded the number of options for investors looking to establish exposure to precious metals. The SPDR Gold Trust (GLD) is the second largest U.S.-listed ETF by total assets, and has become one of the largest holders of bullion in the world. Interest in silver ETFs is considerably smaller–the worth of physically-backed funds is about $10 billion–but still represents a very active corner of the ETF market. Exposure to silver isn’t limited to physical replication, as there are a handful of ETFs that present a way to play the precious metal through bullion, futures, and mining stocks. Below, we highlight four different ETFs for investors looking to bet on a continued rally in silver prices [see all silver ETFs]:

iShares Silver Trust (SLV)

One of the most popular options for gaining exposure to silver prices is SLV, which seeks to offer investors returns that correspond to changes in the spot price of the precious metal. SLV does this by holding silver bullion in secure vaults in London, England. SLV currently has more than 10,000 tonnes of silver, which equates to almost half of the silver produced annually from mining activities (recycling of silver adds a material amount to the total supply of the metal).

The physically-backed structure has several advantages for investors looking to gain exposure to commodity prices. Because the underlying holdings of SLV are bars of silver, shares of this ETF will generally exhibit perfect correlation to spot silver prices. Returns to futures-based funds, on the other hand, depend on not only movements in spot prices but the degree of contango or backwardation in markets and prevailing interest rates [read Five Things BusinessWeek Didn't Tell You About Commodity ETFs].

For most commodities, the physically-backed structure isn’t possible. Holding crude oil or livestock presents considerable logistical challenges, while the costs associated with storing most metals would erode returns significantly (though several issuers are currently planning physical copper ETFs). Silver is by far the cheapest of the precious metals–even after the recent rally gold is still fifty times more expensive–but the value-to-weight ratio is high enough to make the physically-backed structure feasible from a cost perspective.

ETF Securities, the London-based issuer that has been quite successful with precious metals products in the U.S. in recent years, also offers a physically-backed silver ETF. The underlying assets of the ETFS Physical Silver Shares (SIVR) are also silver bars; the biggest difference between the two physical silver ETFs is the expense ratio. SLV charges 50 basis points, while SIVR’s fee is just 30 basis points [see The Definitive Guide To Silver ETFs].

PowerShares DB Silver (DBS)

This ETF offers investors exposure to silver prices without ever investing directly in bullion. DBS seeks to replicate the Deutsche Bank Liquid Commodity Index – Optimum Yield Silver Excess Return, a benchmark composed of futures contracts on silver. The Optimum Yield line of indexes seeks to minimize the negative effects of rolling futures contracts when markets are in contango and maximizing the positive effects when markets are backwardated.

So far in 2010, DBS has delivered impressive returns but lagged behind physical silver ETFs by about 80 basis points. In certain environments–for example, when interest rates are higher than current levels–the futures-based approach may deliver higher returns than a physically-backed fund [also read The Ten Commandments Of ETF Investing].

Global X Silver Miners ETF (SIL)

Some investors are hesitant to establish exposure to assets that have no ability to generate cash flows and will never make a dividend or coupon payment (e.g., gold and silver). Although there are some industrial uses for silver, the prices of all precious metals tend to fluctuate with investor outlooks, leaving them sensitive to potentially large price changes and the vagaries of a complex market.

In recent years, ETFs offering “indirect” exposure to natural resources through stocks of commodity-intensive companies have become increasingly popular. Because the profitability of these companies is often tied to the prevailing market prices for their end products, these equities often exhibit very strong correlations to the related commodity. And because of fixed costs in place at mining companies, the stocks generally trade as a leveraged play on spot prices.

SIL offers investors a way to establish exposure to silver prices through the stocks of companies that are engaged in the exploration and extraction of the precious metal. This ETF replicates the Solactive Global Silver Miners Index, a benchmark that consists of companies engaged in mining, refining, and exploration for silver. SIL has about 25 individual holdings, with the heaviest weights afforded to stocks listed in Canada, Mexico, and the U.S [see which ETFs offer the most exposure to any country by using our free Country Exposure Tool].

Since its inception in April of this year, SIL has gained more than 60%, and has added more than 20% over the last month.

ProShares Ultra Silver (AGQ)

This leveraged ETF offers a way for investors to double down on silver; AGQ seeks to deliver a return of 200% of the return on the daily performance of silver bullion (as measured by the dollar fixing price for delivery in London). Like most leveraged ETFs AGQ resets its exposure on a daily basis, meaning that it won’t necessarily deliver amplified returns on spot silver over multiple trading sessions.

For those looking to bet on a pullback in prices, the bear counterpart to this fund, the ProShares UltraShort Silver (ZSL) might be an interesting option.

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Disclosure: No positions at time of writing.