Concerns About PHYS [Correction]

May 20, 2010

Let me preface this by saying: I like gold. I believe it has a role in a portfolio and, in fact, I even bet our Research Director Dave Nadig a steak dinner that gold would hit $1,200 before it hit $1,000 again. (Looks like it's time to pony up the filet mignon, Dave.)

[CORRECTION: A previous version of this blog said that PHYS was not able to issue new shares. That was incorrect. Like any publicly traded security, PHYS can issue new shares subject to SEC approval. Indeed, it did so last week, issuing more than 24 million additional units for gross proceeds in excess of $275 million.

The author intended to point out the difference between a closed-end fund like PHYS and an open-end exchange-traded fund like GLD. GLD has the obligation to continuously issue new shares based on participant demand, whereas PHYS has the option of creating new shares at the issuer's discretion.

PHYS performs as described in its prospectus.

We apologize for the error.]


I say this because, well, it's hard out here for a gold investor sometimes—and by "gold,” I'm specifically talking about the SPDR Gold Trust (NYSEArca: GLD), the quickest, easiest way for average investors like you and me to access the stuff in meaningful quantities.

At just under $50 billion in assets under management, GLD is now the second-largest ETF on the market. But despite its size—or perhaps, because of it—GLD's caught a lot of flak from some circles. In particular, certain ardent, imaginative gold bugs remain convinced that SSgA's gold ETF is merely a cog in the greater machine of precious metals price fraud and market manipulation.

Don't trust GLD, they say. (Sometimes they even include GLD's nearly identical twins, the iShares COMEX Gold Trust (NYSEArca: IAU) and the ETF Securities Physical Swiss Gold Shares (NYSEArca: SGOL) in their dire warnings). They'll rattle off GLD's list of counterparty risks as listed in the prospectus, or some made-up numbers about how much gold GLD should hold, and how it can't possibly hold that. But in the end, it all comes back to this message: GLD's just a conspiracy between big banks to bilk you of your hard-earned cash. It's all a scam.

No, it isn't.

To be honest, I'm more concerned about the alternative to GLD.

Of course, I don't mean the bullion dealers, although there are plenty of dishonest people in that business. But depending on where you buy it, holding physical bullion instead of GLD shares can actually make more sense for buy-and-hold investors, since the annual costs of custodying that gold at a place like Kitco or BullionVault can sometimes turn out to be cheaper than GLD's 0.40 percent annual expense. In fact, that price differential is one of the reasons we've seen a lot of big funds, like David Einhorn's Greenlight Capital, switch over to physical gold in the past few years.

But my ire is directed at a particular gold fund, the Sprott Physical Gold Trust (NYSEArca: PHYS). (Dave covered the fund shortly after its launch.) Designed to "invest and hold substantially all its assets in physical gold bullion,” PHYS is often held up by conspiracy theorists as a safer alternative to GLD, because it allows investors to take physical delivery of the underlying metal.

You see, one of the biggest charges conspiracy theorists levy against GLD is that you can't redeem your shares for physical bullion—and that in itself is a smoking gun of suspicious activity.

You know what? They're right. You can't redeem your GLD shares for the underlying bullion, just like you can't redeem your SPY shares for the underlying S&P 500 stocks, unless you're an authorized participant. ETFs just don't work like that.

But PHYS isn't an ETF. It may be a fund that trades on an exchange, but as it states in its prospectus, it is a "closed-end mutual fund trust." And therein lies the rub.

One of the things that makes ETFs unique is that authorized participants (essentially, a class of institutional investor) have the right to create new shares of ETFs at fair value on a daily basis. They typically do this by purchasing the underlying securities held by the ETF and delivering them to the ETF issuer in exchange for shares in the fund; alternatively, they may sometimes deliver cash or other securities.

The constant creation mechanism helps keep the price of the ETF in line with its fair value, since the authorized participants will arbitrage away any pricing premium in the fund.  .

Conversely, authorized participants can redeem shares as well, usually when the ETF is trading at a discount to fair value; the system just works in reverse.

With PHYS, the creation and redemption mechanisms are different.  As a closed-end fund, PHYS does not have a continuous creation process. The fund can issue new shares --- indeed, it did recently, issuing more than 24 million additional units for gross proceeds in excess of $275 million.  But the choice to issue new shares is made by the issuer, which must file with the SEC every time it wants to issue more shares.

PHYS does have a redemption mechanism. Indeed, this is what attracts people to the product, since it allows individual investors to redeem their holdings for physical gold bullion (as long as they are redeeming at least one London Good Delivery Bar, or about $500,000).  Smaller redemptions are allowed in cash.  The issue is that redemptions are only allowed once a month, with a 15-day lag.

The result is that, like any closed-end fund, there's little keeping PHYS' share price in line with the value of its gold holdings. And the data show that PHYS’ price fluctuates significantly away from its net asset value. Currently, the fund trades at a premium of 15.7 percent—meaning if you buy PHYS, you are paying 15.7 percent above the value of the gold it holds. And that number has been much higher:



Premium (Discount) Frequency Distribution

Source: Sprott Asset Management

This hasn't stopped a flood of security-obsessed gold bugs from swarming the fund. PHYS, which launched in February, already trades over 1 million shares a day, and has $441 million in assets under management.

And there's the greatest irony: Gold bugs panicking over GLD's connection to physical gold instead have flocked to an closed-end fund whose value has significantly deviated from the actual price of gold.

It's OK to ask questions and, like we always say, every investor should do his or her due diligence before choosing an investment. But in the case of PHYS, investors who are purchasing at a premium are paying serious cash to avoid what seems to us like a better-constructed ETF, simply out of paranoia and fear.

All things considered, GLD's a pretty rock-solid fund. Its gold bars—all 1,200 or so tons of them—are kept in HSBC's
London vaults, and the holdings are audited multiple times every year by two different parties. Security measures for the vault resemble that for gold reserves kept by central banks. SSgA posts the full holdings of GLD up on its Web site every day, and the list of gold bars is updated every Friday. Frankly, if there were gold missing, or if GLD didn't hold the gold it claims to, we'd know by now.

Like I said, I like gold, and I think it can play an important role in your overall portfolio. But not all that glitters is worth your investment—especially if you're buying out of fear.

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