PHYS: Not A Gold ETF, And A BAD Deal

March 02, 2010

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.



The Big Tax Trap

But those flaws pale in comparison with the “exciting feature” that ETFdb notes in its article: the tax treatment.

According to the fund's prospectus, “Any gains realized on the sale of units by an investor … may be taxable as long-term capital gains (at a maximum rate of 15% under current law).”

It sounds like the Holy Grail. One of the vexing problems of funds like the SPDR Gold Trust (NYSEArca: GLD) is that, no matter how long you own it, you will owe 28 percent taxes on gains because the IRS considers all gold investments to be collectibles. PHYS claims to have found a way around this problem, creating a gold bullion fund that qualifies for true long-term tax treatment. Brilliant!

Except it's not.

The IRS isn't stupid. It's going to get its money somewhere. And in this case, it looks like it's reaching into the pockets of PHYS' most loyal, buy-and-hold investors to grab that 28 percent for the U.S. Treasury.

Understanding why gets into the weeds of the prospectus, but it's important to do, because the implications are huge. Here's the relevant paragraph:

"If any holder redeems his, her or its units for physical gold bullion (regardless of whether the holder requesting redemption is a U.S. Holder or an Electing Holder), the Trust will be treated as if it sold physical gold bullion for its fair market value in order to redeem the holder's units. As a result, any Electing Holder will be required to currently include in income his, her or its pro rata share of the Trust's gain from such deemed disposition (taxable to a Non-Corporate Electing Holder at a maximum rate of 28% under current law if the Trust has held the physical gold bullion for more than one year) even though the deemed disposition by the Trust is not attributable to any action on the Electing Holder's part."

Let me parse that for you.

You, Mr. Long-Term Buy-and-Hold, purchase shares of PHYS and stuff them deep in your portfolio, confident that you'll only pay long-term gains of 15 percent when you eventually decide to sell. Meanwhile, a hedge fund buys shares of PHYS, rides them while gold is rising, and then redeems them back to the fund company.

To meet this redemption, the trust either sells a pile of gold to pay cash or redeems out physical gold bars. Either way, the trust will book that sale with the IRS based on the current price as gold, and will be taxed at the 28 percent collectible rate on any gains. But funds never actually pay taxes: They pass them along to shareholders. So that 28 percent gain accrued by the hedge fund activity? That's going to be paid by you, even though you never sold a share.

I guess I'll have to agree with the headlines—that's certainly an exciting feature. I suppose getting a root canal without the gas is “exciting” too.

ETFs treat all investors fairly. PHYS not so much.

Find your next ETF

Reset All