Seeking Alpha
Long/short equity, special situations, arbitrage, options
Profile| Send Message|
( followers)  

Central Fund of Canada (CEF) has been providing a reliable stock market vehicle to invest in precious metals since 1961. CEF is a closed-end fund investing in gold and silver and is an alternative to GLD and SLV. As a closed-end fund, it can trade at a premium or discount. Please see chart below for the time series of how it is traded relative to NAV. It is easily seen that CEF has, for the last 8 years or so traded at a premium to its NAV. Now, in this precious metals sell-off, it has begun trading at a discount. It is currently trading at a 6.5% discount, which is close to the largest discount since June 2005. The question is whether this is an opportunity to buy gold and silver at a discount to their market prices or whether the discount widens further.

(click to enlarge)

(source Bloomberg)

First, let's look at the mechanics. The Fund makes it easy to calculate the NAV. The Fund's site provides all of the relevant information. Currently, the Fund holds ~1.7M oz of gold and ~77M oz of silver, plus ~$40M cash. Simply use the exact values from the site and multiply by current spot prices for gold and silver and then the cash to calculate total NAV for the Fund. Divide by the number shares, which is also given on that page. This is all straightforward. Be sure that you are using the spot price of the metals, not GLD, SLV or futures prices. Keep in mind that for gold, spot has recently traded slightly above the active futures price, which is unusual, particularly when the futures curve is in contango.

If one does some additional research, including reading the annual report [pdf], there is some key additional information to be aware of. First, management of the Fund will periodically sell additional shares. Check the notes on pages 11-12 regarding Capital Stock. On three occasions, in 2009, 2010, and 2011, additional shares were issued. On April 6, 2011 the Fund issued shares and that drove the premium down to zero and below (see graph above). The premium re-appeared but at a lower average level than where it had been since 2005. Offerings in 2009, and 2010, do not appear to have impacted the premium for Fund shares. One final important tidbit worth mentioning is also in the Capital Stock note: since October 1989, class A stockholders (the shares) can redeem their shares for 80% of the NAV of the fiscal quarter.

Down with a Discount

Now we can verify current market prices of CEF and its NAV and we see that we can get this basket of precious metals at a 6.5% discount to current spot prices. It is clearly an attractive proposition to purchase the metals cheaper than what the market is currently offering. CEF is a closed-end fund (I won't abbreviate it as CEF to avoid confusion with the Fund), and there is no creation/redemption mechanism for keeping the market value of CEF in line with its NAV. The only mechanisms available are investor rationality, the 80% redemption mentioned above and the ability of CEF management to issue more shares. Statistically, CEF has traded at a premium for the past 8 years or so and it seems reasonable that trading at a premium is "normal." At first glance, scooping up CEF at a discount seems like a no-brainer.

However, for all of that time, gold and silver have been in a bull market. During a bull market, it makes sense if investors were perhaps too aggressive in their purchases of gold- and silver-related assets. So it is worthwhile to look at CEF performance prior to 2001 when gold was at the bottom of its last bear market. Here is a graph going back to April 1986 (source: Bloomberg):

(click to enlarge)

Now the picture looks very different. One can see the premium seems to be correlated to the trend of gold. To get a better handle on this, I will create a series to proxy the "trend of gold" as the weekly close of spot gold divided by its 52 prior weeks' moving average less 1. This will give a percentage "premium" of the weekly close to the moving average. The idea being that it will parallel the percentage premium of the weekly closing price for CEF. The following graph shows the two time series (source Bloomberg).

(click to enlarge)

And here is a scatter graph with regression line. In both, there are some outliers, but the basic story that the premium of CEF is closely correlated to gold's trend is accurate; 77% of the sample can be found in either the top right or bottom left quadrants, meaning that direction matches, even if magnitude is less predictable.

(click to enlarge)

The Opportunity

There are two ways to take advantage of this. Choose CEF to get long precious metals as an alternative to buying gold and silver in some other way or to create an arb type position if one is neutral on metal. The key to this trade is that you need the discount to diminish. There is no yield or other advantage accruing to the holder (CEF does pay a small .01 annual dividend but it is small enough to effectively ignore). Currently, gold is 22% below its trend as I defined it above. For the indicator to go positive would require gold to bounce to $1600/oz; $1600/oz does not look likely in the short term.

I believe that 6.5% discount is a good entry point. It still comes with risk. At the extreme, CEF is willing to compensate investors with 80% of the NAV via a redemption process that is untried (as far as I know). There has yet to be sufficient discount to motivate investors to exchange. That makes a hard-ish floor of 20% discount and that seems unlikely, but not impossible. On the other hand, the market could print 10%+ discounts in another sweep down of precious metals and overall risk-off trading. My personal view is that gold is due for a bounce and quarter end could be the catalyst.

To construct an arb trade, one would need to buy an amount of CEF and offset it with an appropriate short in gold and silver. Based on the numbers from CEF, it holds 45.42 ounces of silver for every ounce of gold. Each share of CEF has .00666 oz of gold (1.7M oz / 254M shares - check data for exact figures). Table 1 shows equivalent positions. Note that equivalent positions means combined gold and silver positions vs. CEF position. This is because CEF holds both gold and silver. An example trade would be long 1450 CEF, short 450 SLV and short 100 GLD. There will be tracking error as the positions do not match exactly, but they are small relative to the discount.

Table 1: Equivalent Ratios

Per Ounce

Per GC Future

Per 100 GLD

Gold/GLD

1 oz

100 oz

100 shares GLD (9.6643 oz)

Silver/SLV

45.42 oz

4,542 oz

454 shares SLV (439 oz)

CEF

150 shares

15,013 shares

1450 shares

There are some advantages and disadvantages to using GLD and SLV (or other ETFs). The first advantage is that being short GLD and SLV accrues the expense ratio in your favor. That is, if gold is unchanged, the value of GLD declines over time to represent the loss of metal as the administrator removes some of the metal to pay for fees. In addition, the expense ratios for both GLD and SLV are higher than that of CEF, which is typically 0.31% (see the annual report for further details). Another advantage is smaller resolution; that is, one can trade smaller positions with more accuracy. For instance, trading the 100 oz future would require a mis-match of the 5,000 oz silver (SI) contract against a desired position of 4,542 oz. And, of course, any futures position held for some time would potentially require rolling contracts. The main disadvantage is that metals ETFs are taxed at a higher rate than futures. Check this article for a recent story about this. There is no way to address each individual's tax situation; this article addresses my market outlook and the mechanics of the trade. Please make a note of margin implications for putting on an arb structure as margin will increase on the short leg if gold rises and might cause an issue for an inappropriately funded account. Any potential trade is something an individual decides for themselves.

Conclusion

A look at the history of CEF premiums shows that its pricing is correlated to the trend of gold. That makes sense and it can be viewed as a bit of a sentiment indicator on gold direction. Gold and silver have sold off in a manner indicating liquidation. It is now just before quarter end and it seems reasonable that the timing might mark a turning point as institutions finish adjusting their balance sheets for the reporting period. Purchasing CEF at a discount to the market price of its assets is clearly an attractive proposition. Nevertheless, it pays to go into a trade with one's eyes open. It is reasonable that the discount could expand toward 10% or more if sentiment worsens. On the other hand, if one is bullish on precious metals, and precious metals do rise, the discount will likely disappear adding an additional 6.5% return to one's investments. The arb looks attractive to begin stepping into. My feeling is that it is not time to take a particularly large position, but it does seem likely that positions will get re-set or initiated after quarter end that will act to add liquidity to areas that have been stressed in this recent yield sell-off.

Source: Central Fund Of Canada: Down With A Discount

Additional disclosure: Short GLD, SLV for arb.