New ETFs: Bullion Equivalent or Metal Facade?

Fri, Mar 12, 2010 - 12:00am

Due to my ongoing interest in palladium, I decided to investigate the new platinum and palladium exchange traded funds sponsored by ETF Securities. They just started trading in the US under the symbols PPLT (for platinum) and PALL (for palladium) after a nine month regulatory process.

I was somewhat surprised that the new ETFs were approved in half the time of GLD. The Commodity Futures Trading Commission has recently taken a hard line toward funds that hold physical commodities like PALL and PPLT. Last year UNG was forced to sell natural gas contracts, and DBA had to dump large quantities of corn and wheat due to the belief that the accumulation of long positions in these markets was warping them.

Compared to natural gas or wheat, the palladium and platinum markets are miniscule. They are also necessary for industry in applications from catalysts to batteries to electronics. These metals have very unique properties and cannot be easily substituted by other materials. At the same time, deposits of these metals are geographically concentrated with little or no stockpiles, making them vulnerable to supply disruption. Why would the CFTC assume that the palladium and platinum markets can handle a huge influx of physical demand without causing critical shortages for manufacturers?

I noticed that the ETFs both have prospectuses 66 pages long. That seems lengthy for funds that buy and sell metal, store it, and issue shares against this bullion. After all, Graham Tuckwell, the Chairman of ETF Securities described his products as “almost like a warehouse receipt.” The fact sheet itself is only two pages long. What could the additional 64 pages contain?

In addition to these concerns, I had another reason to be skeptical about these ETFs. They are similar to SLV and GLD which have serious governance issues. I won’t duplicate the excellent work of James Turk, who's written detailed analyses of these funds’ shortcomings. To summarize, there is no guarantee that either ETF owns any metal. The bullion could be leased out, moved from subcustodian to subcustodian, or contracts could be settled in cash if a counterparty defaults on a promise to deliver metal. As both GLD and SLV are traded like stocks on exchanges, they can be sold short and therefore a single ounce could have multiple claims on it. I was interested to see if PALL and PPLT followed the “dangerous precedent” of GLD and SLV, or if they created an ETF with high integrity.

As I expected, the prospectuses and fact sheets for PALL and PPLT were almost identical, with most of the text just swapping platinum for palladium. The sections describing the markets and industries varied slightly due to differences in the underlying fundamentals of the two metals. What did surprise me was several instances where verbiage was taken almost word-for-word from the GLD or SLV documentation.

Just as GLD is “designed to track the price of gold,” PPLT is intended to “reflect the performance of the price of platinum, less Trust’s expenses,” according to EFT Securities’ fact sheet. This honestly states that PPLT is a derivative of platinum, despite Tuckwell’s reassurance that “we hold some bullion for you.” As a derivative, it will synthetically attempt to act like metal, but it’s a paper instrument that may or may not have a corresponding bullion backing. The prospectus admits that “Although the Shares will not be the exact equivalent of an investment in platinum, they provide investors with an alternative that allows a level of participation in the platinum market through the securities market.”

Despite the analogies to physical metal, each ounce could have multiple claims of ownership against it. Like SLV and GLD, ETF Securities’ new products allow both “long and short exposures.” As there is no practical way to borrow the metal before selling the shares short, these ETFs are effectively a fractional reserve system. While the short position is currently tiny, it could swell in the future to a level that could distort prices from the metals the funds attempt to track.

The trust is quite aware of this fact. The prospectus states that platinum futures and the ETF could diverge sharply. If illiquidity results, “the price of the Shares may fluctuate independently of the price of platinum and may fall.In fact, “Market and financial conditions, and other conditions beyond the Sponsor’s control, may make it more attractive to invest in other financial vehicles or to invest in platinum directly,” admitting that the ETFs are echoes of physical metal, not the real deal.

Even if the investor is comfortable with purchasing a metal derivative, each share represents a fraction of a constantly shrinking pool of assets. PPLT’s prospectus admits that “the fractional amount of physical platinum represented by each Share will decrease over the life of the Trust. New deposits of platinum ... will not reverse this trend.” This “precious metal” investment actually erodes in value just like a fiat currency due to the trustee (the Bank of New York Mellon) selling bullion to pay its expenses. In addition, the sponsor insists on being paid its annual fee of 0.6% in physical metal even while trying to convince prospective customers of the inconvenience of holding bullion.

While the previous clauses were disturbing, one of the most shocking revelations about PALL was the statement that, “The Trust will not insure its palladium.” If you are expecting the custodian to purchase insurance, it may (or may not) to whatever extent it deems “appropriate.” The trust claims it has no legal power in this area, stating it “does not have the ability to dictate the existence, nature or amount of coverage.” It’s possible that none of the bullion will be insured, as “the Custodian and the Trustee will not require the Zurich Sub-Custodian or any other direct or indirect subcustodians to be insured or bonded.” This potentially leaves shareholders with a loss “for which no person is liable in damages.”

Similar to GLD, the subcustodians may not be monitored in any way, as “the Trustee may have no right to visit the premises of any subcustodian for the purposes of examining the Trust’s palladium or any records maintained by the subcustodian.” Although the prospectuses assure investors that “bullion will be independently inspected biannually by world renowned bullion assayers Inspectorate International Limited,” this company may not be allowed into many of the vaults. PALL copies GLD’s clause which frees the custodian from supervisory responsibility, stating, “the Custodian is not liable for the acts or omissions of its subcustodians.” JPMC may not even know who holds the metals, as “subcustodians may in turn appoint further subcustodians.”

The bank is only culpable “for negligence or bad faith in the selection of such subcustodians,” a difficult standard to meet legally. Custody arrangements are governed by English law, making it difficult for an American court to interpret them. Even worse, most depositories follow “LPPM rules or the customs and practices in the London custody market,” not laws, making it “difficult or impossible for the Trust to sue.” In case of a dispute against the Zurich Sub-Custodian, a court “may disregard that choice of law and apply Swiss law” instead, further muddying the legal waters.

Although Tuckwell touts the safety of an investment “backed by bullion,” the ETFs lack even the consumer protections of mutual funds or commodity pools. The prospectuses specifically state that PALL and PPLT are not covered under the Investment Company Act of 1940 or the rights afforded by the Commodity Exchange Act. These laws cover issues such as disclosing conflicts of interest, trading on regulated exchanges, and manipulating commodity markets. ETF Securities is so wary of these limitations that the trusts will liquidate themselves if the SEC tries to regulate under the first act, or the CFTC determines the second applies.

PALL and PPLT are very different than a closed-end fund like the Central Fund of Canada (CEF) which is a mutual fund corporation. CEF describes itself as “an investment in gold and silver bullion,” not a instrument that reflects the performance of precious metals. This fund charges less than half the fees of PALL and PPLT while avoiding fractional reserves by trading at a premium to net asset value. In addition, it can be bought and sold as easily as ETF Securities’ products, making CEF superior in my opinion.

As a further slap in the face to the consumer, both BONYM and JPMC lack a financially neutral relationship to PALL. These banks reserve the right to “purchase or sell palladium or Shares for their own account, as agent for their customers and for accounts over which they exercise investment discretion.” Just like in the SLV agreement, the trust managers are not disinterested bystanders, but are active participants. They have both the motive and the ability to manipulate this market to boost their profits. According to the prospectus, the trustee can also purchase metal from the custodian, and as we’ve seen with the custodial arrangement, JPMC could collect the money without having to prove any metal was actually delivered.

In addition, JPMorgan Chase is largely protected from consumer lawsuits, and able to reach into the deep pockets of PALL or PPLT when needed. “The Trustee will, solely out of the Trust’s assets, indemnify the Custodian (on an after tax basis) on demand against all costs and expenses, damages, liabilities and losses which the Custodian may suffer or incur in connection with the Custody Agreements.” JPMC is only liable in cases of “negligence, willful default or fraud,” and only responsible for “the market value of the palladium [platinum] lost or damaged at the time such negligence, fraud or willful default is discovered by the Custodian, provided that the Custodian promptly notifies the Trustee of its discovery.” Apparently, shareholders' interests are at the mercy of JPMorgan Chase's desire to tattle on itself, as the trustee has limited rights to investigate for fraud.

My opinion of the Bank of New York Mellon is not much higher. It’s also nearly invulnerable to legal action, and can only be held liable in cases of “gross negligence, bad faith, willful misconduct or willful malfeasance” or “reckless disregard ... of its obligations and duties.” Naturally, trust assets can be sold to cover any legal fees BONYM may accrue. I find it impossible to believe in JPMC's or BONYM's good intentions when this prospectus makes them nearly judgement-proof.

With a custodial agreement containing large loopholes and admissions that investments in the ETFs are similar, not equivalent to bullion purchases, I doubt the assurances that physical metal “is not subject to borrowing arrangements with third parties.” Since the trustee can’t reliably inspect the metal, who knows where it is or if it exists? The custodian, subcustodians, and sub-subcustodians could lend out bullion once it’s delivered, or ship it out to cover their other shorts with no one the wiser.

I am also skeptical of the assertion that the funds don’t use derivatives and that the bulk of the metal is “not subject to counterparty or credit risks” considering the parties involved. With almost no oversight, I am supposed to believe that the top holder of derivatives (JPMC) and the seventh biggest player (BONYM) holds every ounce they claim? In addition, the lack of adequate insurance means that any discovery of theft or fraud could have a devastating effect on shareholders.

I’ve asked myself why such flawed products for essential and relatively rare metals would be approved now, especially with very tight stocks in both palladium and platinum. PALL and PPLT are permitted even though it seems to contradict past CFTC actions breaking up ETFs that accumulated long positions in commodities.

My theory is that the US financial elite know that palladium is already in a supply deficit because of Russian stock depletion, and platinum could easily slip into one at any time because unreliable South Africa is the source of 78% of the metal. The authorities allow PALL and PPLT to begin trading, siphoning off a sizeable percentage of demand for the corresponding metals into these paper investment vehicles (about 10% according to Johnson Matthey). Since these ETFs have many custodial loopholes and they are run by banks known for dirty dealing, fractional reserve accounting for the bullion is likely. The new products have the extra bonus of diverting some gold and silver demand, in addition to absorbing pent-up interest in platinum and palladium.

If much of the expected physical diversion to ETFs does not occur as I suspect, industrial users won’t sense a deficit, so they won’t hoard. Advisory services like JM have downplayed the risk of potential shortages in the media, keeping commercial customers calm, even though the hazards are apparent in their own reports! Costs are kept artificially low, and the price inflation barometer is unable to warn US consumers of the financial storm still beyond the horizon.

It’s no secret that I am a big fan of precious metals. However, PALL and PPLT are derivatives of bullion, not actual metal. With the poor governance of these paper instruments, I can’t recommend them as investments.

I’m aware of no remote bullion service that offers palladium, but you can always purchase coins and bars through a dealer. This plan truly has no counterparty risk.

Copyright © 2010 Jennifer Barry

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