By Dr. Jeff Lewis – Edited by John Fisher
Another Reason to Fear ETFs
Regardless of their expensive annual fees, frequent tracking errors, and the simple fact that you’ll never be able to actually touch the gold or silver your ETF claims to hold, there are several more reasons ETFs should never be used by precious metals investors. An important rule change by COMEX, the American commodity exchange, allows ETF substitutes for precious metal delivery.
Paper as Metal
To address a “temporary” problem of liquidity, COMEX has systematically created an even bigger problem for investors. The exchange allows investors to make good on their futures contract positions with gold and silver ETFs rather than the real assets, thus opening up the door for hugely distorted market prices. In other words, traders are now able to settle their futures contracts with a paper certificate, not physical metal as has always been required.
How it Works
Under the clause 104.36 in the COMEX rulebook, exchanges can take place on the exchange as long as the products meet certain criteria. After sorting through legalese, investors find that the criteria isn’t as demanding as one would expect from a multi-trillion dollar exchange, but is actually quite loose. COMEX requires that exchanges be made in economically equal products. For instance, a 1000 ounce silver ETF position can be substituted for 1,000 ounces of physical silver, despite their inherent differences.
This creates immense problems for investors, as well as the exchange itself. First, no silver actually trades hands, but only a silver derivative that has supposed claims to silver. Second, the exchange-traded fund is economically similar in that it has equal worth to the same amount of silver; however, investors cannot receive physical delivery from the ETF issuer. In essence, purely derivative investments are equal to physical metals in the eyes of COMEX, even though the reality is quite different.
Further Complications
Reading from the prospectus of the two biggest gold (GLD) and silver (SLV) exchange-traded funds reveals that through the COMEX marketplace, paper can really be turned into gold! The popular SLV ETF discloses in its prospectus that there are times when the exchange-traded fund will hold cash, or cash equivalents, allowing itself the opportunity to issue more shares than the silver it actually holds in the trust.
In addition, the exchange-traded fund has the ability to make claims against third parties (a derivative) to track the price of silver on the marketplace. This opens the door for large manipulation in the silver markets, as investment dollars in the ETF can be placed on derivative bets. Then the shares can be exchanged through COMEX to meet delivery on futures positions.
The result is that derivative products owned by SLV can easily find their way into what is supposed to be a purely physical market, distorting the actual amount of silver compared to what is actually in existence in vaults.
What it Means for Investors
ETF investors are clearly at a disadvantage, although the chance of manipulation is only a bullish signal for physical investors. COMEX rules have allowed artificial inflation of the amount of silver futures available prices, and it is sure that physical metals will only gain in value as this comes to light. There is simply no better investment than physical metals both for the short and long term.
All Things Considered – John’s Commentary:
Thought of the day: Gold and silver ETFs have a significant derivative component. Warren Buffett refers to derivatives as “financial toxic waste”. Although many would contest that both physical metal and ETFs allow investment in the sector and achieve the same result, examine carefully. In the left hand you hold a gold and silver coin or bar. In the right hand you hold a paper prospectus and account statement. My left hand is counter-party to no one. My right hand is counter-party to numerous people and organizations, most of whom I don’t know.
What to do now: Continue to accumulate slowly. The market may well trade sideways for months as it continues to consolidate its gains in piercing $1,000. Additionally, it needs to build a firm base from which to launch its next climb. We should be very happy with a prolonged trading range at present levels. The stronger the base, which only comes with time, the stronger the launching pad.
What to buy now: With the gold:silver ratio standing at 68.75, continue to favor silver over gold. Pre-1965 silver coin and 100 ounce silver bars are the best buy. In gold, the lower the premium the better. Premiums are continuously fluctuating, so please call.
