Pulled the Trigger on Silver Today as Bounced Off Support & Trend Line

May 26, 2010

For my blog today, I thought I would post a response to an e-mail I received from a loyal listener. Below are his questions, then my response.

Hi Dan,

I have a question about the reliability of the ETF SLV. I have been wanting to add Silver plays into my portfolio and I hear you mention SLV on your show. However, the more I research it, it sounds like there is a sizeable crowd out there that warns against SLV (and GLD) because their reasoning says its not a “real” play on Silver, rather a play on a bunch of paper that does not really guarantee the ETF holds the actual commodity of silver. I’m confused and to the point to where I don’t know who to believe.

Also I heard you mention CEF on the show as a quick Gold + Silver play for those who own neither. That would be me. But in researching that I am seeing that it’s a tax-nightmare for taxable trading accounts and best for a tax-deferred account. I want to get into both Gold and Silver soon, but I’m not sure I want to be in for a tax debacle of my own creation by buying CEF.

What are your thoughts? Anything you can say would be greatly appreciated.

________________________

Both SLV and GLD are supposed to be backed by the actual commodity/metal. As more people invest, they have to go out & buy and store the physical metal. Can there be a “squeeze” and the fund not be able to buy and take delivery of the metal due to too much leverage worldwide of paper assets backed by gold/silver and a shortage of the physical metal, probably. But that is another reason to be bullish.

This doesn’t mean the price of the ETFs won’t go up. When you think there will be problems with delivery, that is when you might consider selling your “paper” gold & silver, and keep the physical metal you own. Another alternative is to buy the mining shares, GDX, but again, that is “paper” backed by the assets of mining companies just like any stock or ETF, and most companies use leverage or borrow.

The point I am trying to make is that with any stock or ETF (“paper” equity), you are buying part ownership of the assets of the company. The stock certificate is simply the contract and evidence of ownership of the buildings & assets of the company, just like the physical metals are the assets backing these ETFs. Could management of the companies mismanage the assets they are charged to operate, sure.

You have this risk with ANY stock or bond that you own, bonds are just more senior in pecking order in the event of bankruptcy. Only when you hold the physical asset yourself do you not have to worry about mismanagement. But then you have to worry about holding & storage cost (hiding it), insurance cost, theft, high spread when bought and sold etc..

This is why it is not about any one investment, because there is not one perfect investment. It is about overall portfolio construction and how the entire portfolio correlates and interacts with all the other assets in the portfolio. Therefore, you do not want to be too heavy in any one asset. Every person I know that is over worried about an individual stock has too much. You should never invest/purchase more that 6-8% in any one stock period, or 15-20% of an ETF.

This way you will only have “systematic” or market risk and can diversify away from “unsystematic” or company specific risk. Now the question becomes, how do you handle systematic or overall market risk.

That is why 1/2 my research is not about the fundamentals of the companies or sectors (the other 1/2 is), but what the investors are doing, the demand and supply of stocks. Even though Modern Portfolio Theory tells you it is all about your risk tolerance, I disagree. It is HOW MUCH RISK IS IN THE MARKET! When the market has a lot of risk, I want to be out or hedged. When the market is relatively safe, that is when I want to “take risk” or own equities.

Every asset can have only 2 of 3 qualities – growth, safety, & liquidity. You want all 3, but there is not a public investment that has all 3. That is why it is important to have different assets, some that have high growth potential & liquid, but has risk and doesn’t have guarantees/safety (stock).

Then you can have an asset that has a high degree of safety and the potential for growth, but is not liquid and you lock your money up for a time period (structured notes & bonds). Lastly, you can have an asset with safety & liquidity, but without growth potential (money markets & short term notes).

Therefore, you want various assets so you have the enough safety, you have enough growth, and you have enough liquidity when you need it.

Sorry about the long winded response, but I though it important for you to understand. It is NOT about any individual investment, but the overall portfolio.

Now, for your Central Fund of Canada “CEF” question. Yes the accounting is slightly different and you will get the proper forms after year end by the company. My taxes are already a “nightmare,” so one additional minor thing is not going to sway me away from a good investment.

The one good thing I like is that it is Canadian, therefore, outside the jurisdiction of the US regulators. It might actually provide some diversity within the Gold & Silver sector. Therefore, you could have some GLD, SLV, and CEF, as well as some mining shares and GDX Gold Miners ETF.

Good questions, and keep studying,
Dan Stewart CFA®