Silver ETF vs. Silver-Linked Structured Note (ETF: SLV)

The Associated Press ran an interesting story about adding precious metals to a portfolio as a hedge against inflation (Some Advise Adding Metals to Portfolio). The article focuses on Bayclays effort to launch a silver ETF, announced earlier this year, and the brouhaha that ensued when a lobbying group for industrial silver buyers asked the SEC to reject the application. At the time of this writing, the SEC is still considering Barclays application, so quiet period rules have constrained Barclays in what they can say.

The AP article largely speaks for itself and is a good read for the uninitiated. But the discussion of structured products as an alternative to a silver ETF is one part of the article that I felt warranted additional commenary. The article reads:

Another option is a structured note, a vehicle typically offered by financial institutions for wealthy investors. With these notes, investors get a return that is linked to the performance of certain metals over a set period, such as five years. On maturity, investors get their initial principal back, plus a cut of the performance of the underlying metals.

Raymond James Financial Inc. has offered structured notes this year linked to metals and indexes. The firm developed a four-year principal-protected note in June around five industrial metals — aluminum, copper, nickel, lead and zinc — and the FTSE/Xinhua Index of 25 Chinese companies. The product, called the China note, is currently up 6 percent, said Fred Whaley, managing director of Raymond James’ alternative-investments group in St. Petersburg, Fla.

Clients typically invest $25,000 to $50,000 in the notes. “We’ve been offering them this year because of the interest in commodities,” Whaley said. The products are designed to provide exposure to metals, but with added diversification to protect against swings in metals prices. “We have investors who think they want (metals) but don’t understand the risk of volatility in the marketplace,” he said.

I’m a big believer in retail derivatives, but let’s be very clear here: a structured note is an imperfect substitute for a true silver ETF. After all, structured products in general are hardly transparent: the people on Wall Street who create them are called “rocket scientists” because of the complexity of the instruments. In addition, with a structured note, the broker’s commission is usually built into the yield on the note. Unlike a stock trade, in which you pay the share price of the stock plus a defined commission of, say, $10, bond brokers usually pack the commissions into the cost of the note, and sometimes charge an additional commission on top of that.

A silver ETF would solve both of these problems. In an ETF, like a conventional mutual fund, there is a single number called the expense ratio that captures the costs that the management company collects. In addition, since most retail ETF trading takes places in the aftermarket, you can be quite confident that your broker is not getting a commission on your ETF purchases.

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