Physical Silver Trust Premium Collapses – Pairs Trade Returns 10%

by ETF Base on May 5, 2011

With the various precious metals ETFs out there and the volatility we’re seeing in the markets now, there are opportunities to exploit market inefficiencies that appear and disappear rather quickly (see more on arbitrage investments).  But investors that are agile can benefit as these scenarios repeat themselves somewhat frequently.  In the past, I benefited from a gold pairs trade when I witnessed a runaway premium on the Sprott Physical Gold (PHYS).  More recently though, on March 23 I posted about a lucrative silver pairs trade using the Sprott Physical Silver Trust (PSLV).  As of Thursday’s trade, you would have made a 10% (pretty much) risk-free return on just over a month.  Here’s how.

Silver Pairs Trade Explained

As outlined initially, PSLV is a closed-end fund so it carries a premium/discount to the underlying net asset value.  The primary reason investors have been rewarding this CEF with such a generous premium is because of conspiracies surrounding the inability of the more popular iShares Silver ETF (SLV) to ever meet underlying silver requirements.  There is also some tax efficiencies in PSLV as well, which is a legitimate reason to confer some premium over a competing SLV which is subject to more onerous precious metal tax rates since it’s treated as a “collectible”.

As of the initial article posting, the premium on PSLV was 24% over NAV which I argued was way above the mean.  Mean reversion should bring it back into the low-teens.  That’s what happened.  So, regardless of the direction of silver itself (which has been all over the place in recent weeks), by simply shorting PSLV an equal amount with a long position in SLV, an investor could simply capture the decrease in premium with a net zero cash outflow.  It’s beautiful.  And it worked!

As of Thursday, the premium on PSLV was around 11% (here’s the link to Sprott’s website listing real-time NAV premiums).

So, compression of the premium from 24% down to 11% in a few short weeks would have returned a double digit return.  Not too shabby for assuming virtually no risk, right?

Unfortunately, at the time I tried to repeat my gold pairs trade where this was successful previously, I couldn’t find the PSLV shares to short.  It’s hit or miss; some days the brokerage has shares to short, other days it doesn’t.

What’s the lesson here?  Markets aren’t always efficient.  There are opportunities for investors who can follow what’s going on, are willing to take some unconventional approaches to boosting returns, and who follow the right blogs!  Follow the ETFBase RSS or Email Newsletters for free HERE.

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