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By Alex Bryan

Palladium certainly does not receive as much press as other precious metals, such as gold or silver, but it can be just as useful for investors. An investment in palladium is an indirect bet on the automotive market. From 2009 through 2011, the automotive industry accounted for 60% of the gross demand for palladium, a key input for catalytic converters. Industrial demand for palladium is cyclical. In fact, over the past three years, palladium’s beta relative to the S&P 500 Index was 1.25. Supply disruptions can also have a significant impact on palladium prices because more than 80% of the world's palladium reserves are concentrated in Russia and South Africa. Johnson Matthey, a leading catalyst producer, estimated that supplies coming to the market from Russian stockpiles declined 68% in 2012. Meanwhile, output from South African mines also slid last year, as mine workers went on strike and safety stoppages were implemented. In combination with supply-side constraints, a rebound in global auto production and the substitution of palladium for platinum in the light diesel market may increase demand and put upward pressure on palladium prices.

ETFS Physical Palladium Shares (NYSEARCA:PALL) offers exposure to the spot price of palladium minus expenses, by owning physical palladium bullion stored in vaults in London and Zurich. PALL could serve as a tactical bet on the global automobile industry, tightening emissions standards, or as a way to profit from a renewed strength in the consumer electronics market.

Palladium shares many of the same industrial applications as platinum. However, because it is less expensive, palladium is more widely adopted. Although platinum and palladium were 0.78 correlated over the past five years, palladium was more volatile. During that time, palladium spot prices exhibited a standard deviation of 40.3%, while the corresponding figures for the S&P 500 and platinum spot prices were 19% and 31.6%, respectively.

Fundamental View
A post crisis rebound in demand from the automotive market is providing a near-term tailwind for the palladium market. Also, many auto producers continue to substitute lower-cost palladium for platinum in catalytic converters. While palladium is already more widely adopted in gasoline engine exhaust systems than platinum, this substitution effect has recently picked up in the light diesel market. This substitution may help offset weak demand for new vehicles in Europe resulting from high unemployment, economic uncertainty, and government austerity measures. In the United States, pent-up demand for new vehicles is fueling strong sales growth. Our equity analysts see this growth continuing into 2013. Despite a recent surge in inventory, this should lead to an increase in production, which would likely increase demand for palladium.

Over the long term, tightening fuel efficiency standards in the U.S. could have a material effect on palladium demand. However, the direction of that demand shift depends on how auto companies adjust their product mix to meet the new standards. Smaller engines emit less exhaust. Consequently, all else equal, catalytic converters would require less palladium or platinum to meet emissions standards. However, according to a report by Johnson Matthey, "Platinum 2012," if auto manufacturers compensate for smaller engines by adding turbochargers to preserve power, the average temperature of the exhaust would fall. This would require a larger amount of palladium or platinum to process. Similarly, if auto manufacturers produce more hybrids, a greater amount of palladium or platinum would be required for rapid "light-off," as the engine turns on and off more frequently. Alternatively, if consumers adopt electric vehicles more widely, the demand for palladium could decline.

Outside the automotive industry, palladium is used to manufacture electronic circuit boards and jewelry and as a catalyst to produce industrial chemicals. In the electronics industry, palladium is facing tough competition from non-precious metals such as nickel. However, palladium's superior durability makes it a better alternative for automotive electronics systems, where it is used in circuit board multilayer ceramic capacitors. Palladium has also found a niche in men's jewelry, but the jewelry market only represented 6% of the total demand for palladium in 2011.

Russia boasts the richest deposits of palladium in the world. It supplied nearly half the market in 2011. However, according to Johnson Matthey PLC, the quality of available Russian palladium ore is declining, which may increase the cost of production and reduce the amount the country can supply in the future. Adding to this supply constraint, the Russian government will likely be a smaller net supplier of palladium in the future, as previous sales have largely depleted its stock. This could put upward pressure on palladium prices. Growing stocks in Zimbabwe, and a return to normal production conditions in South Africa, may partially offset a potential decline in supply from Russia.

Portfolio Construction
PALL is structured as a grantor trust. Unlike most ETFs, this trust does not track an index. Instead, it holds palladium bullion, stored in vaults in London and Zurich. The fund’s per share net asset value reflects each share’s proportional ownership of palladium at the most recent London PM Fix price. The trust sells platinum to cover its expenses, which will gradually dilute each share’s palladium-ownership stake over time. Because realized gains on precious metals are taxed as collectibles, this ETF would be most appropriate for tax-sheltered accounts.

The trust levies a 0.60% expense ratio. Although this fee is high relative to most gold and silver ETFs, PALL is the only palladium exchange-traded product available. Under current tax laws, long-term capital gains on this investment are taxed as collectibles, meaning they are taxed at ordinary income rates, capped at 28%. Like most traditional investments, short-term capital gains are taxed at ordinary rates and are not subject to this cap.

The simplest alternative to owning this product may be to own physical palladium, either in the form of jewelry or ingots. However, insurance costs and the relative illiquidity of these physical assets make this an unappealing alternative for most investors. Although PALL is the only palladium exchange-traded product on the market, platinum has very similar industrial applications as palladium, particularly in the automotive industry. Consequently, ETFS Physical Platinum Shares (NYSEARCA:PPLT) may be a suitable alternative. Over the past two years, PALL and PPLT were 0.91 correlated. PPLT charges a 0.60% expense ratio.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: Palladium: Gold's Grittier Cousin