Friday, April 28, 2006

The wasting assets of GLD and SLV ETFs

Will all the hoopla about the introduction of the iShares Silver ETF (SLV): investors seem to have forgotten a big gaping flaw in the design all the metal ETFs.

None of the metal ETFs own any income producing assets. Metal itself is dead, and therefore fund expenses (0.40% for (GLD) or (IAU), 0.50% for SLV) are taken from the ETFs bullion holdings. Every day the amount of gold or silver backing an ETF share shrinks. As silver ETF's Prospectus helpfully explains:

The trust sells silver to raise the funds needed for the payment of the sponsor’s fee [...] and all trust expenses or liabilities not assumed by the sponsor. The purchase price received as consideration for such sales is the trust’s sole source of funds to cover its liabilities. Impact of Trust Expenses on the Trust’s Net Asset Value

For example on Jan 03 2006, each share of streetTRACKS Gold Trust (GLD) held 99.552% of 0.1 troy ounces of gold, today on April 27 2006 each share of GLD holds 99.433% of 0.1 troy ounces of gold. On GLD's inception date November 18th 2004 each share held 100.00% of its starting NAV. You can watch your GLD vanish on the official streetTRACKS website.

An commodities fund like DB Commodity Index Tracking Fund (DBC) or United States Oil Fund LP(USO) that uses futures does not have the problem because interest from the bonds deposited as margin for future contracts is used to pay fund expenses and offset losses due to contango.

A simple solution for NAV erosion is for the gold and silver ETFs to lend their bullion and collect "leasing" fee's. The fees would be used to offset fund expenses and increase fund assets/pay dividends over time. Alternately each share of an ETF would be a unit could consist of metal and a preferred share of a trust that invests in treasury bonds/mortgages/TIPS. I.e each share of GLD would consist of 0.1oz of Gold and a preferred share of par $10. Income earned by the trust in excess of fund expenses would be paid as dividends on the preferred shares. Whenever a creation transaction occurs, the preferred shares would be redeemed or issued as needed.

Many equity ETF's lend their securities to short sellers to generate fee's from short interest. These earnings are used to offset fund expenses. The current precious metal ETF's policy of holding only physical bullion and having no source of income requires erosion of NAV to pay fund expenses. This makes metal ETFs questionable as a long term investment or store of value.


At April 28, 2006 6:20 AM, Anonymous petronius said...

Thank you for articulating this important point! Those who buy and hold these metal etfs will see their investment erode to near nothing within 25 yrs. In addition, tax treatment will be unfavorable - if held for more than a year, gains on these assets will be taxed at a maximum rate of 28%, compared with 15% for stocks. Eventually the market will have to discount these negative features in the etfs' prices.

At April 28, 2006 3:32 PM, Anonymous neildo said...

Does CEF (Central Fund Of Canada) have the same asset erosion problem? If not, how do they cover their expenses?

At May 01, 2006 1:53 PM, Blogger Rick said...

The CEF faces the same problem. It offsets the problem to a very limited degree with minor holdings of interest bearing securities. However, in the first quarter, interest income totalled only $89,000 compared to administrative, custodial, accounting, and legal fees which totalled $844,000 for the quarter. The total amount of interest bearing securities to pay off these administrative costs is about $8.2 million, versus a run rate of expenses at about $3.5 million per annum, consequently, there appears to be no near term need to sell any gold.


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