Why Premium Concerns for PSLV Are Overblown

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 |  Includes: PSLV, SLV
by: Mike Scully

As of the close of markets on April 21, 2011 the premium on the closed end fund PSLV (NYSEARCA:PSLV) was at 22% of net asset value. Why on earth would anyone pay that kind of premium for a silver ETF when they could buy SLV at almost no premium or physical silver at a few percent over spot?

That question has been the topic of several articles on Seeking Alpha and other financial sites. Most of them slam the high premium and conclude that people who buy PSLV despite the steep premium, are either conspiracy theorists or fools looking for a bigger fool to sell to. One article recommended going long SLV while shorting PSLV to play a kind of premium arbitrage game. (I don’t know why you need arbitrage when you can just buy silver and watch it go up.)

In this post I won't get into the validity of various so called conspiracy theories on silver manipulation except to say that some percentage of silver investors are concerned that the silver in SLV's vaults may be otherwise encumbered. They note that JP Morgan is by far the largest holder of short silver futures contracts and also the custodian for SLV. Regardless of the truth of such claims, in this case, the perception becomes the reality. Since SLV is 16 times the size of PSLV, it only takes a fraction of silver investors to feel this way.

This perception may partly explain such a large premium. Or, perhaps as one person postulated on the PSLV message board, JP Morgan can't get the physical silver to cover its shorts so it is willing to pay a 22% premium to obtain silver from PSLV instead of a rumored 30-80% premium to settle its contracts in cash instead of physical silver. In any case, if obtaining physical silver becomes more difficult or takes longer in the future, the perception of shenanigans by JP Morgan, and thus the premium, will only grow.

But outside of any manipulation, there are more mundane reasons why PSLV should warrant a fairly high premium. First is the convenience factor. The fund holds and stores the silver so investors don’t have to deal with transaction costs, shipping costs, storage fees, the small risk of theft, etc. This is a bigger factor in silver than in gold due to the price per ounce. It is also one reason the premium on PHYS is much lower than PSLV. Second, is that it can be traded like a stock so investors can keep it in their IRA or other accounts and trade easily if needed. Third, and perhaps most importantly, is the treatment of the fund as a long term capital gain which is currently taxed at 15% as opposed to the bogus “collectibles” tax rate of 28%. These three factors far outweigh any management costs or other factors that would lower the premium. Whether the premium attributed to those three factors is 5%, 10% or 30% is anybody’s guess, but it’s certainly in positive territory.

One argument against the near record high premium, which has some merit, is that the premium on PSLV should experience a reversion to the mean and perhaps even overshoot to the downside. The problem with this argument is that the fund is only six months old and there aren’t enough data points to establish a mean. The premium has experienced a slow, steady rise since the fund’s inception. Who’s to say the premium won’t continue to rise to 40% before returning to a mean of 25%?

But even if the premium does return to the mean of around 15%, investors who are extremely bullish on silver may still prefer PSLV to SLV. The chart below shows the after tax gains of SLV and PSLV at different premium levels at the point of sale. (Assuming long term gains)

After Tax gains of SLV and PSLV

Silver down 20%

Silver up 0%

Silver up 20%

Silver up 100%

SLV

-20.0%

0.0%

14.4%

72.0%

PSLV (premium stays the same 22%)

-20.0%

0.0%

17.0%

85.1%

PSLV (premium drops to 15%)

-24.6%

-5.7%

11.2%

75.3%

PSLV (premium increases to 30%)

-14.7%

6.6%

23.7%

96.2%

Click to enlarge

As the chart shows, if silver experiences substantial gains as it has the past year, the after tax return on PSLV can beat SLV, even if the premium were to regress to the mean of 15%. If the premium stays where it is or increases, the difference in returns can substantially favor PSLV.

The large premium would be a problem if you intended to take physical delivery as outlined in the prospectus. But most owners of PSLV are simply using the fund as a convenient way to own physical silver and don’t intend to take physical delivery. They just act as if the option is available and it’s one more assurance that the silver that PSLV claims to have is actually there and totally unencumbered by paper promises.

One of the main psychological reasons people invest in silver is to protect their wealth in a financial system that has all kinds of crazy financial instruments and counter-party risk. PSLV owners trust the good name of Eric Sprott and the storage and audit practices of the fund. Does that warrant a 22% premium? That's up to you to decide. Just be sure you know all the implications of the high premium.

Disclosure: I am long PSLV, PHYS.