A few weeks ago, Sprott Asset Management, a Canadian firm owned and operated by Eric Sprott, filed to launch its third physically backed closed-end fund, worth $115 million.
First off, let’s dispel any misconceptions about what an ETF truly is. To the vast majority of investors out there, an ETF is an open-end fund traded on an exchange that at its core has all the benefits of the creation/redemption mechanism that keeps its price pegged, as closely as possible, to its net asset value.
Calling a closed-end mutual fund an ETF, as Reuters did in a story about Sprott’s plans , simply because it trades on an exchange—is wrong. Dave Nadig and I are on the same page on this. He had a similar complaint almost two years ago about the launch of the Sprott Physical Gold Trust.
Poor Alternatives To Gold And Silver
Investing in physically backed funds is a safe haven for jittery investors. The benefit of holding physical gold and silver is to guard against economic, political or social instability—the more uncertain the outlook, the higher the prices of gold and silver.
Meanwhile, platinum and palladium perform a bit differently in the market, and may not be ideal alternatives to gold and silver.
Platinum group metals (PGMs) have many industrial applications in manufacturing. According to the World Gold Council, 66 percent of platinum and 93 percent of palladium are used in industry, compared to 11 percent of gold.
Therefore, the prices of platinum and palladium partly depend on the demand for the products that they help produce. In other words, platinum and palladium are more tied to cycles of industrial demand than gold and silver.
The graph below illustrates the price of gold versus platinum per troy ounce. Note the drop in price of platinum during the unraveling of the 2008-2009 market crash, as well as the surge in gold prices in late 2011 brought on by tension in the Middle East, S'P’s downgrade of U.S. debt and the European sovereign debt crisis.
For savvy investors who already knew this, arguing that the Sprott Physical Platinum and Palladium Trust is a convoluted investment is hardly a stretch.
The platinum/palladium fund is markedly different from its physically backed sister funds—Sprott Physical Gold Trust (NYSEArca:PHYS - News) and Sprott Physical Silver Trust (NYSEArca:PSLV - News)—since it combines two precious metals in one fund.
Putting platinum and palladium into one fund makes no more sense than if you combined gold and silver. Actually, it makes less. In the last decade, the correlation between the price of gold and silver has been 95 percent, compared to 76 percent between platinum and palladium.
This could partially be explained by the fact that platinum is much more of a “discretionary” metal than palladium. According to the World Gold Council, the demand for platinum as an investment and for jewelry is five times higher than it is for palladium. By contrast, gold demand is only 2.5 times greater than silver for discretionary spending.
In the future, this trend is likely to continue as more efficient technology is developed to replace the use of platinum in autocatalysts by the cheaper metal—palladium.
You Don’t Get What You Pay For
Most often, the reasoning for buying into a physically backed precious metal closed-end mutual fund—as opposed to futures-based funds, commodity ETNs or equity ETFs—is that ownership in such a fund, like Sprott’s, represents a claim on a segregated, verifiable amount of physical assets.
In other words, investors can redeem their shares in bullion, instead of cash. Fair enough, but how much of each would investors own in a two-metal fund?
Well, it turns out that investors would get somewhere around twice as much palladium in the Sprott’s physical platinum and palladium fund, according to a passage on page 16 of the prospectus:
“The Manager intends to purchase approximately equal dollar amounts of each of physical platinum and palladium bullion in an aggregate amount approximately equal to net proceeds of the offering less the amount to be held by the Trust to pay ongoing expense.”
In laymen’s terms, shareholders will be left with owning more bullion of whatever is cheapest at the time of purchase. Because platinum averaged $1702.6 per troy ounce over the past year versus $724.6 for palladium, a bit of back-of-the-envelope math yields the conclusion that investors will own more than twice as much palladium as they would platinum.
Furthermore, on the same page, the prospectus says that the amount of physical platinum and palladium bullion a redeeming shareholder is entitled to receive may not be “in proportion to the value of the physical platinum and palladium bullion held by the Trust.”
Simply put, combining two metals in one fund with no guarantee on the type of bullion redemption is a gamble.
Investors may be better off getting exposure to both metals with two separate investments. At least then they aren’t left with crapshoot exposure and a grab bag at the time of redemption.
Perhaps the root of my rant has to do with the fact that physically backed metals in a closed-end fund wrapper exist in a no man’s land. Often, they are difficult for investors to enter and exit at low cost.
If investors want quick precious metals exposure, why not settle for open-end funds, such as the ETFS Physical Platinum Shares (NYSEArca:PPLT - News) and the ETFS Physical Palladium Shares (NYSEArca:PALL - News)? PPLT and PALL are real ETFs, as I defined them above, meaning their prices and net asset values are by design meant to converge.
At the end of the day, in any physically backed fund—closed end or ETF—managers chip away at bullion to pay off redemptions and other expenses.
So, for investors who really want to own the physical metal, why not buy bullion directly? The amount you’d own would stay the same—plain and simple.
Yes, storing bullion may be tricky, but it also guarantees complete control over the investment, which is more than you can say for what Sprott is offering.
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