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May 5, 2006 4:31 pm

Trading silver that fits your pocket

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The launch of an exchange-traded fund never used to occasion much fanfare. But last week’s debut of the iShares Silver Trust had quite a warm-up. With different accounts of how the fund would go about buying and storing silver circulating, the ETF contributed to this year’s sharp run-up in silver before it had even been launched.

The launch lived up to the hype. There were expect­ations that the setting up of the fund, and the extra interest it created, would stimulate a big demand for silver. That turned out to be a self-fulfilling prophecy. On April 28 the ETF traded 2.34m shares, making it one of the biggest ever launches and a great success for the American Stock Exchange. After its first day its shares closed 7.1 per cent higher at $138.12.

Meanwhile, silver futures contracts rose more than a dollar, or 9.3 per cent, to $13.63 an ounce – an extra­ordinary single-day boost for a commodity already well understood by investors.

Traders reported that investors believed the iShares managers would be forced to go out and buy more silver to meet demand for shares in the fund.

So as far as the market was concerned, this launch was a huge deal. Does this mean investors would be well advised to buy into the fund?

This inquiry provokes two more questions: is it a good idea to buy extra exposure to silver? And, if so, is this ETF the best way to do it?

The bull case goes as follows: both precious metals (most notably gold) and basic materials (notably copper) have had strong run-ups recently, so silver looks like a commonsense way to play both trends. It is a precious metal but has more industrial uses than gold, particularly in film but also in electronics. Supply is relatively constricted.

Assessing the value of a precious metal – whose intrinsic value is essentially psychological – is difficult and its recent price performance makes it look dangerously overpriced. Following the ETF’s debut, silver has risen by 55 per cent so far this year and has more than doubled over 12 months. It far outpaced even gold, which gained about 25 per cent during the first four months of the year.

Buying it at these levels does not look likely to provide much of a hedge against inflation. But the investor base for precious metals is widening, a phenomenon from which the ETF should benefit. There is at least a case to buy silver.

Is the ETF the way to do it? It has the great advantage of convenience. Anyone with a brokerage account can buy this fund, and subsequently trade it, at a price that is updated during the day. The exposure to silver is direct – while other commodities funds have invested in futures, iShares Silver will hold silver bullion in a vault in London, so the exposure to the metal is direct.

In return for the convenience come the costs. Barclays plans to charge 0.5 per cent a year, which will be paid for by selling silver. That means that the amount of silver supporting each share will dwindle over time – by about 10 per cent over 23 years, for example.

There is also more potential for the shares to trade at a discount or premium to net asset value than with most ETFs. Even on the first day of trading the share price gained 2.2 percentage points less than the silver futures price. The net asset value of the underlying portfolio will be computed every day soon after the 4pm close of trading in New York, and there will be opportunities for arbitrageurs if the gap between the NAV and the share price grows too large, but the problem is real.

New shares can be issued only in baskets of 50,000 (where each share is backed by 10 ounces of silver). These shares are created when “authorised participants” – a group that includes Barclays Capital itself, Bear Stearns, Citigroup, Goldman Sachs, JP Morgan, Merrill Lynch and UBS – buy silver, place it with the ETF and notify the trust that they want the new shares in return.

This mechanism ensures that the spread between NAV and share price need not widen too much but will also create some friction along the way.

Note that this system means the ETF only causes what John Dizard described in FTWealth earlier this year as an “evolution” in silver investing, and not a revolution. The ETF will only buy silver when there is investor demand for it, and does so 500,000 ounces at a time – nothing like the 130m ounces that some had predicted the fund would buy at its launch.

If you want to track the evolution of this demand you can do so on the Barclays iShares website, which will be updating details of its silver holdings daily.

So, in total, the mechanism is not able to respond to changes in market prices as quickly as a stock-based ETF can but it can adjust fairly quickly and at a cost that is significant but acceptable to many investors given the convenience.

And for those who think it is time to sell silver, this fund has one big advantage. Selling silver short is typically a cumbersome task for your average retail investor – or even quite a wealthy one. With this ETF, betting against silver should be much easier.

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