PHYS: Not A Gold ETF, And A BAD Deal

March 02, 2010

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In the words of Star Wars' Admiral Ackbar: “It's a trap!"

I guess you know your town is on the map when the carnies show up and start taking the rubes.

Last week, the “Sprott Physical Gold Trust” started trading on the New York Stock Exchange under the ticker PHYS. Almost immediately, the media starting singing its glory: “New Gold ETF Prospectus Reveals Exciting Feature,” wrote Seeking Alpha contributor ETFdb. Invest with an Edge had similarly glowing coverage.

Unfortunately, PHYS is not an ETF. And its “exciting feature?” Well, that turns out to be a trap.

Not An ETF

I define an ETF as an open-ended mutual fund that trades on an exchange and uses a creation and redemption mechanism to keep its share price in line with its NAV.

PHYS trades on an exchange, but the comparisons stop there.

The company doesn't try to hide this. The prospectus states:

"The Trust is a closed-end mutual fund trust established under the laws of the Province of Ontario"

As a closed-end fund, PHYS comes with all kinds of warts that do not apply to ETFs. For starters, PHYS was sold at a 5 percent commission. That is, the price offered to initial investors in the fund was $10 a share, but the NAV took an immediate haircut to $9.50, because 50 cents went into the hands of the good folks at RBC Dominion Securities, Morgan Stanley
, BMO Nesbitt Burns and other underwriters. ETFs never come with initial underwriting commissions.

That might not matter to investors who purchase it on the open market, but there are other warts that do.

For instance, as with all closed-end funds, there is no way for PHYS to issue new shares, which means there is effectively no way for the security to actually track the price of gold. Sure, it might, but if the shares trade at a premium, it's impossible for an arbitrageur to go buy gold, turn it into shares, sell them on the open market and drive the market price back to NAV.

PHYS does have a redemption feature, but it's severely crippled. The PHYS redemption window is only open once a month, and it comes with a lag. Investors who want to redeem shares of the fund can submit a request to the company on the 15th of the month. If the redemption request is large enough (bigger than a single gold bar), the redemption will be processed at least in part for physical gold at NAV at the end of the month (13-15 days later). If you're redeeming lots smaller than a physical gold bar or just want cash, you get dinged for at least 5 percent off of the value of the fund.

That's not exactly a liquidity option. Let's just say that market makers aren't lining up to ride this “lightning-quick” 15-day flawed redemption process to ensure that the fund stays close to fair value.



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