Gyroscopic Investing

As I learn and read more about the various Gold ETFs/ETNs/Funds, arguments arise over the inability for an investor to redeem shares for underlying gold. And some people then counter-argue that you can't take your S&P 500 shares and redeem them for the correct underlying stocks.

So then I started thinking, why does anyone want a fund that you can't redeem for the underlying stuff? I don't necessarily mean the average investor should be able to do it, but the arbitrageur with $100M should be able to do it. Otherwise, the low-level investors like us could get screwed by the whims of the market external to the market forces on the underlying fund assets.

If you could redeem, and the discount to NAV got too low, that wealthy arbitrageur or hedge fund will step in, buy up all the shares, and redeem/liquidate. The act of that arbitrage puts a positive upward force on the stock price to reduce the discount and bring the fund price back to NAV. This would prevent the discount from getting too low, which screws over long-term fund holders.

But if you can't redeem, then what's to stop the discount from dropping to to 1% of the NAV? My best guest is the dividend in the case of assets that spit off dividends. For example, suppose the dividend of the S&P 500 is 2%. If an S&P 500 fund had the discount drop to 50% of NAV, then that fund would ultimately be giving a 4% dividend, which is a fantastic deal, so people would come in and buy it up, pushing the fund price back up to NAV, arbitraging that dividend gain until there was no discernible discount to NAV. Same with bond funds.

But with gold, there are no dividends. It's a piece of paper saying you own gold in a vault that you can never touch, never redeem, never access, and never get any payments from. The best you can do is sell that paper to someone else who wants to own a piece of paper that can't be redeemed for gold.

The only reason that gold fund doesn't drop to $0 is likely because perhaps even if there's no redemption opportunities, if someone or some hedge fund bought up enough shares, they could vote to liquidate the fund and sell the underlying assets. That should keep the discount from getting too low, because at a certain discount level, it could be a valuable arbitrage opportunity for someone with enough assets. I also imagine that this effect works on stock and bond funds as well.

On a side topic, what's this about PHYS being able to issue new shares if the premium goes too high? Issuing new shares helps dilute the value and reduce the premium... but who benefits from that? Does the fund manager just get to say "well I'm issuing 1 Million new shares at $40 each, and I will keep that $40M as my annual bonus" or does the fund manager have to use that $40M to buy more gold to stuff in the vault, which essentially means all of the existing shareholders are net-unchanged?

Closed end funds generally don't have a redemption feature.  ETFs do (I think always) - but not for you, or even a $100M whale.  Only for "authorized participants" (usually major banks).

Then what keeps the market price of closed end funds dropping to 1% of NAV?

coinstar wrote: The only reason that gold fund doesn't drop to $0 is likely because perhaps even if there's no redemption opportunities, if someone or some hedge fund bought up enough shares, they could vote to liquidate the fund and sell the underlying assets. That should keep the discount from getting too low, because at a certain discount level, it could be a valuable arbitrage opportunity for someone with enough assets. I also imagine that this effect works on stock and bond funds as well.

Exactly.  The ultimate hammer is the fund can decide to dissolve.  If this happens, the assets are sold (at NAV) and the proceeds distributed to the fund holders.  If you owned shares of such a fund, you'd get 100x the current market price as the proceeds from the dissolution.  If a closed end fund were selling at 1% of NAV, a $100M whale could buy the shares, take over the board, and forcibly dissolve the fund.  So, effectively, this can't happen.  The question is at what discount would this be a reasonable option?

coinstar wrote: On a side topic, what's this about PHYS being able to issue new shares if the premium goes too high? Issuing new shares helps dilute the value and reduce the premium... but who benefits from that? Does the fund manager just get to say "well I'm issuing 1 Million new shares at $40 each, and I will keep that $40M as my annual bonus" or does the fund manager have to use that $40M to buy more gold to stuff in the vault, which essentially means all of the existing shareholders are net-unchanged?

The way it works is the fund approaches some market makers who collectively put up a few $100M.  If the prevailing premium is (say) 20%, the deal the fund offers the market makers is something like this: "We'll create a bunch of new shares backed by the same amount of gold as the existing shares, and we'll charge you only a 10% premium for these shares.  You can short them right now.  We'll go buy the gold and then announce the share creation at the 10% premium issue price. This will collapse the premium from 20% to 10% (the day we announce).  That day, you cover your shorts with the new shares we issue.  You make a ton of money, basically risk-free.  The fund makes some money, too (because the fund charged you 10% more than the gold costs)."  The amount of gold each share corresponds to remains constant - but the premium suddenly drops.  You may or may not view this as "net-unchanged".

With ETFs, this same kind of deal is always available to the APs (in either direction - shares for stuff, or stuff for shares) with the significant difference that the fund makes no money whatsoever on the deal (the APs make money, the fund doesn't).