Pairs Trade in Gold Funds Works Out Beatifully – Sprott PHYS vs. GLD

by ETF Base on May 26, 2010

Today, the Sprott Physical Gold Trust (PHYS) completed a follow-on offering of trust units at $11.25 per unit.  This was performed in order to acquire physical gold bullion in accordance with the Trust’s objective and subject to the Trust’s investment and operating restrictions.  In other words, the big selling point of this closed-end fund is that investors can actually request delivery of their gold.  Many true gold bugs believe other gold ETFs like (GLD) could never deliver (or own) the assets should there be a financial panic and a run on physical gold.  While Europe’s in shambles, the US has its share of crises in the year ahead, with strategic defaults becoming the “new black” and the government’s insatiable appetite for debt over spending cuts.  These fears had resulted in a substantial premium to net asset value (NAV) in PHYS but this follow-on offering priced shares more in accordance with true NAV, dragging the share price down with it today.

Massive Premium Came Crashing to Earth

Given the fears over paper gold versus the real thing, along with a legitimate benefit to gold tax treatment for other gold investments like GLD (treated as a “collectible”) which should warrant some premium, the premium to NAV on PHYS approached absurd levels earlier in March to the tune of 30% at one point.

In a recent post on an optimal Gold ETF Pairs Trade I highlighted the opportunity to engage in a long/short trade (which I undertook myself) whereby you could short PHYS while buying an equal dollar amount of GLD Long. The thinking was that while there would likely always be some premium on PHYS over NAV, the premium was fluctuating so much on a daily basis, that even a return to the mean at a premium level would result in a virtual risk-free return in no time.  And it did.

My initial post was on May 10 and I opened the suggested pairs trade at that time.  Since then (intra day May 26 closed out position), the spread between GLD and PHYS grew to 6% (GLD was up slightly while PHYS lost 5.5%).  Today alone, the spread was 7% so I was actually in the hole 1% prior to today’s move.  Therefore, this pairs trade paid off at 6% with no net cash outflow (only needed a margin account, but since I went long/short equally, there was no cash outflow) in 2 weeks.  I won’t beguile you with an annualized return on this, but in my mind, it was some of the easiest money I’ve ever made – I made several hundred bucks on zero dollars down.  I just wish there were more shares to short when I undertook the position.

Looking Forward

Inevitably, the premium on PHYS will continue to fluctuate and when similar opportunities present themselves in the future, I may very well back up the truck this time.  To reiterate, I don’t take issue with PHYS commanding a premium to NAV.  I don’t even take issue with a double digit premium per se.  What I don’t see as sustainable is when the long-term premium is say, 15% and it spikes to 25% on a single day.  To me, this says “Pairs-Trade!”.

Disclosure: Author has closed out short PHYS position and still retains some GLD for a net long gold position as well as other precious metals ETF (more on those) hedged positions.

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