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Why pay a premium for a commodity?
Article Posted on 03-31-2011  363 Views

Why would anyone pay more for precious metals than they’re worth?

That’s the mystery confronting investors looking at several closed-end bullion funds that now change hands well above the market value of the assets they hold.

Sprott Physical Silver Trust (PHS.U-T17.560.130.75%), which is only listed in U.S. dollars, is trading at a 19-per-cent premium to net asset value (NAV). And Silver Bullion Trust (SBT.UN-T23.27-0.55-2.31%) and Claymore Silver Bullion Trust (SVR.C-T14.950.181.22%), respectively, carry a premium of nearly 19 per cent and 2.6 per cent in Canadian dollars.

Unlike mutual funds or exchange-traded funds, closed-end funds issue only a limited number of shares (hence the “closed-end” label). Because their share price is determined by investors’ enthusiasm, rather than being tied to the value of the underlying assets, it’s not unusual for closed-end funds that invest in stocks or bonds to stray from their NAV.

It seems unreasonable, though, for closed-end funds that invest strictly in precious metals to trade well above their NAVs, because prospective investors always have the alternative of buying the underlying commodity for less.

“It’s insane [to pay a huge premium] if there is really no unique benefit to holding that product versus another similar one,” said Dan Hallett, director of asset management at HighView Financial Group.

“If something is in high demand, and is going to incur a cost to buy anyway [such as storing and insuring bullion], maybe a 2-or 3-per cent premium might make sense,” Mr. Hallett added. But double-digit premiums may not be sustainable, and could lead to losses for an investor if the premium falls and the underlying investment doesn’t rise substantially in value, he added.

Industry executives suggest the premiums on the closed-end funds are largely driven by investors in the United States. By buying and selling Canadian-domiciled bullion investments, Americans can qualify for a lower capital-gains tax of 15 per cent versus the 28-per-cent rate for “collectibles,” which includes U.S.-based bullion funds.

“For U.S. investors, it’s a big tax benefit,” said Som Seif, chief executive officer of Claymore Investments Inc., operator of the Claymore Silver Bullion Trust. “If I were a Canadian investor, I would not buy at a premium … A premium of 3 to 5 per cent is one thing, but when you see a premium of 10 per cent or above, I don’t think there is any value or benefit to an investor [even in the U.S.].”

The American influence is demonstrated by the fact that funds interlisted on both U.S. and Canadian exchanges tend to carry the biggest premiums. Sprott Physical Silver Trust, which is interlisted, saw its premium peak at more than 22 per cent last week. Claymore Silver Bullion Trust is not interlisted, but there are plans to interlist it in the future.

David Baker, institutional sales broker at Sprott Asset Management LP, suggested the premium on the Sprott bullion funds also stems from some large investors having the option to redeem shares and receive the physical metal, a feature not available among most peers. In addition, the metals are stored by the Royal Canadian Mint, a Crown corporation, instead of at a financial institution where there is potential counter-party risk.

Among interlisted funds investing in gold, Sprott Physical Gold Trust (PHY.U-T12.630.131.04%) has been trading at a premium of nearly 4 per cent recently. Central Fund of Canada (CEF.A-T21.650.010.05%), which launched in 1961 as gold-only investment and later added silver, has been trading at around a 9-per-cent premium in Canadian and U.S. dollars. But its younger, gold-only sister fund, Central GoldTrust (GTU.UN-T52.38-0.17-0.32%) trades closer to NAV at around a 2-per-cent premium in both currencies.

“We don’t really know why a premium widens or shortens, other than supply and demand,” said Michael Parente, a member of the audit committee of Central Fund of Canada.

U.S. investors are drawn to Canadian bullion funds because of memories of 1933, when U.S. government confiscated privately owned gold amid a run on banks for the metal, Mr. Parente said. “We get lots of calls from U.S. investors who like the fact that we … do not have that history.”

Some U.S. investors worry about their country’s debt spiralling out of control, he said. “There are concerns about their own U.S. dollar. They feel that they are far better off invested in gold and silver, which they consider to be money.”

Rather than paying a premium to invest in a gold or silver closed-end fund, Canadian investors might want to investigate exchange-traded options like the Claymore Gold Bullion ETF (CGL-T12.920.141.10%) or iShares COMEX Gold ETF in Canada. But there is also Precious Metals Bullion Trust (PBU.UN-T18.040.060.33%), a closed-end fund managed by Brompton Funds Management Ltd. that trades at a 1-per-cent discount to NAV in Canada.

This fund, which invests in gold, silver and platinum bullion, could be interlisted in the future, acknowledged Chris Cullen, a senior vice-president at Brompton Funds. It’s a move that might drive up its share price as it draws interest from Americans. “It is an attractive option that we would consider going forward,” he said. “It seems to work quite well for our competitors.”

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