Fear and uncertainty abound in today's markets, renewing interest in precious-metals exposure. This leads, yet again, to questions about the reliability of the most popular offerings. At the centre of this discussion sit physically backed precious-metals products like SPDR Gold Shares (GLD) and iShares Silver Trust (SLV), which consistently swing large premiums and discounts to spot prices.
In the wake of early August's substantial correction, GLD and SLV developed discounts as large as 1.79% and 7.25%, respectively. Given the numerous enquiries that we have fielded, we are compelled to address the issue here.
Premiums and discounts for physically backed precious-metals offerings are not typically an indication of an under- or overvaluation. They are the byproducts of disjunctions between the timing of net asset value calculations and market price trades.
A Look at the Data
Concerns about significant premiums and discounts are not unfounded. We consider the total cost of ETF ownership to extend beyond mere management fees. Investors should carefully consider the impacts of both bid-ask spreads and premiums and discounts. By nature, they are costs that can easily surpass the expense ratio as the primary drag on returns over shorter holding periods.
For most traditional equity ETFs, premiums and discounts are generally mild. It isn't unreasonable to expect these funds to see daily deviations from NAV lower than 10 basis points. For the year to date, the average absolute daily deviation from NAV for SPDR S&P 500 (SPY) has been a mere 2 basis points. This being the case, we advise against purchasing a traditional equity ETF while it trades at a substantial premium. For the more exotic offerings, such tight tracking is not the norm, though it should not dissuade investors from participation.
Shifting our gaze from U.S. large-cap equity to fixed-income, international, and commodity-focused exposure, we find that premiums and discounts widen significantly. Across the ETF universe, physically backed precious-metals offerings consistently suffer some of the largest premiums and discounts to their NAVs. For the year to date, SPDR Gold Shares' average absolute daily deviation from its NAV was roughly 44 basis points. IShares Silver Trust averaged a whopping 170 basis point daily deviation.
Such sizable disjunctions raise serious concerns about the reliability of these vehicles' pricing. Further, they can present investors with the illusion of under- or overvalued access to the asset class. On Aug. 4, SLV closed at a 7.25% discount to its net asset value. Opportunistic investors looking to establish a silver position may have found the scenario quite enticing, assuming that the ETF traded at some price below the value of its bullion holdings. The well-informed would have understood that the circumstances were most likely created by a simple time lag.
NAV and Closing Market Price: Snapshots in Time
To understand why physically backed precious-metals offerings suffer the most significant price dislocations, one must first understand how a premium or discount is calculated.
Premiums and discounts arise when the market price of a particular security does not fall in line with its NAV. The NAV is the per share value of the total pool of assets held by the fund. For precious-metals offerings, NAV should equal the value of all bullion under management divided by the number of shares outstanding. The net asset value, and thus the premium or discount, hinges upon the prescribed "value" of the bullion that the exchange-traded product holds.
The values of gold and silver bullion are "fixed" twice each day by the London Bullion Market Association: once in the morning and once in the evening. Platinum and palladium prices are "fixed" twice a day in similar fashion by the London Platinum and Palladium Market. The evening fixes occur at 3:00 p.m. (GMT) for gold and silver, and 2:00 p.m. (GMT) for platinum and palladium. Because equity markets are still open, any changes in the price of the ETF will understandably cause a premium or discount to develop--with even more scope for this to occur in the case of ETFs traded on the U.S. or Asian markets, while European markets sleep. Physically backed precious metal offerings trade globally, and because the fix occurs only once per day, investors would do best to refer to market prices to approximate the metals' true value.
The Predictive Power of Premiums and Discounts
We now understand that mere time differences cause premiums and discounts, but herein lies a bit of a paradox. Exchange-traded products are built to track their NAVs with pinpoint precision. After bullion prices are "fixed" however, precious-metals ETP prices do continue to fluctuate. This provides anecdotal evidence that the these vehicles drive price discovery. In this case, cash continues to change hands to set the prices of funds like GLD, which are proxies for the underlying commodity.
If our hypothesis is correct and the market's assessments of the fair value of precious metals are manifest through physically backed ETPs, then the next day's NAV should adjust accordingly. That is to say that the next "fix" should move to close any premium or discount that existed.
To test this we set up a statistical study across a number of investable asset classes. We identified all deviations between NAVs and market prices throughout 2010. Running a regression analysis, we were able to show whether or not the premiums and discounts from the previous day were predictive of the movements of each fund's net asset value in the following day.
Click here to view the chart.
Note the funds belonging to the precious-metals category. As mentioned earlier, they maintain extremely high daily premiums and discounts. This is indicated by their far right position on the chart. We also see that the predictive power of those premiums and discounts, calculated via their R-squared values, are the highest of any asset class.
These values indicate that the premiums and discounts created by a changing market price provide substantial insight into the next day's change of NAV. It also tells us that one cannot rely on the existence of a discount to identify undervalued exposure to the asset class.
Legitimate premiums and discounts can certainly develop due to a lack of liquidity, which may cause large bid-ask spreads. They can also occur intraday, due to arbitrage frictions inherent in the creation-redemption process. If, however, your physically backed metals ETP maintains high trading volume and relatively low volatility, it is likely that the incidence of a large premium or discount is the product of differences between the times at which the NAV and market prices are calculated.
