PHYS/PSLV Underwriters Steal $3M+ From Shareholders

This story was interesting. The PHYS gold fund recently issued more shares, via a “secondary offering”. The underwriters exercised a 3M share “green shoe” overallotment option. This robbed the other PHYS shareholders. Do you understand why?

There was a similar 3.5M share overallotment option for a PSLV secondary offering. This also robbed the other PSLV shareholders.

There is a difference, between GLD and PHYS. GLD is an ETF. During the day, market makers buy or short sell shares of GLD. They usually hedge with short or long gold futures. At the end of the day, the market makers can redeem shares of GLD, covering their short hedge. The market markets can trade in gold futures for new shares of GLD, covering their ETF short. This arbitrage process guarantees that the market value price of GLD should stay close to the Net Asset Value (NAV) of GLD.

PHYS is a closed-end fund. There is a fixed number of shares. There was an IPO when the PHYS fund was created. Periodically, the PHYS manager Sprott issues new shares. A corporation can have a “secondary offering” to raise capital. Similarly, the PHYS fund can have a “secondary offering”.

The shareholders of PHYS and PSLV have the right to redeem shares, for gold/silver or cash. This guarantees that the market value of PHYS and PSLV will never be lower than the NAV.

However, PHYS and PSLV can trade at a premium to NAV. The shares are worth whatever people will pay, just like any other stock.

There is a valid reason to prefer PHYS to GLD. If you’re investing in a taxable account, GLD is taxed at the gold collectable rate of 28%. (There may be mark-to-market capital gains every year. I was confused about that bit of tax law.) PHYS is taxed at the long-term capital gains rate of 15%. It’s worth it to pay a slight premium for PHYS, for the more favorable tax treatment.

For GLD, there’s a loophole in the fine print of the fund prospectus. The GLD fund manager may lend gold to short sellers. If there’s a default, GLD shareholders are stuck with the loss, and not the fund manager.

PHYS claims to have 100% full reserves, stored in a vault in Canada. As a practical matter, either GLD or PHYS may defraud people. That’s a risk of any paper gold investment. The PHYS fund structure is more fraud-resistant than GLD, because PHYS claims to be 100% full reserve. With paper gold, GLD is the usual fractional reserve banking scam.

With PHYS and PSLV, the share price may be a premium to NAV. For PSLV, the premium was as high as 30%. For PHYS, it was a couple of percent.

The fund manager Sprott had a “secondary offering”, exploiting the huge premium to NAV. More shares were created, via a “secondary offering”. The shares were sold for a premium to NAV, but a discount to the latest market price. This enabled Sprott to profit the difference. They bought physical gold for the spot price, but collected spot plus premium when selling shares.

The investors in the “secondary offering” also profited. They sold at the market price but bought at the “secondary offering” price. The “secondary offering” is also an opportunity for market makers profitably cover short hedges.

The most evil part was the “green shoe”. Whenever there is an IPO or “secondary offering”, the underwriter gets a “green shoe”. The “green shoe” is an option to buy more shares at the offering price. The underwriter gets 30-90 days to decide whether they want to exercise the “green shoe” or not.

This call option is valuable. The cost is paid by other shareholders, in the form of dilution of their ownership.

A one-month at-the-money call option for GLD is worth approximately $5 per share. PHYS has a share price worth 1/10 that of GLD, making the “green shoe” options worth approximately $0.50 per share. Similarly, the “green shoe” options for PSLV were worth approximately $0.50 per share.

The “green shoe” for PHYS was 3M shares. That’s $0.50*3M = $1.5M stolen from the other PHYS shareholders. The “green shoe” for PSLV was approximately 3.5M shares. That’s another $1.5M+ stolen from the other shareholders.

Even if PHYS and PSLV delta-hedge the “green shoe” option, they still lose an amount equal to the hedging cost. It can get expensive to hedge a small-duration at-the-money short call option. You buy high and sell low if the underlying bounces around the strike.  (in fact, the underwriters are probably delta-hedging their call option.  If PHYS was also hedging, they were literally trading with the underwriters.)

PHYS and PSLV are closed-end funds. Shares can trade at a premium to NAV. Sprott and the banksters profit from this spread. They create new shares at a cost of NAV, but sell them for a premium to NAV. In the process, shareholders who paid a premium to NAV are diluted. The premium to NAV decreases when shares are issued, stealing from shareholders who paid a premium to NAV.  Even worse, the “green shoe” is a free call option to the underwriters, paid by the other shareholders.

The conspiracy theory is “Sometime in the next 5-15 years, there will be a default on a big PM fund.” With GLD, you can get robbed, because GLD holds paper gold and not physical. There is the possibility that the PHYS trustee would lie.  Being “audited” is no guarantee against fraud; MF Global was audited.  Even if the PHYS fund is honest on the 100% reserve part of the prospectus, you still lose storage fees. Even worse, you pay a premium to NAV but get diluted via “secondary offerings”. The “green shoe” is another way that underwriters rob PHYS/PSLV shareholders. The cost of the call option dilutes other shareholders.

The best gold and silver investment is physical delivery, hidden someplace safe. No matter what paper gold investment you choose, you will get robbed.

4 Responses to PHYS/PSLV Underwriters Steal $3M+ From Shareholders

  1. Thanks for the article. Just interested in one thing – you mention that the GLD fund manager can lend gold to short sellers, but when I read the Prospectus it specifically said it didn’t do that :

    “Gold held in the Trust’s allocated account is the property of the Trust and is not traded, leased or loaned under any circumstances”

    So I wonder if you have seen something else which is contrary to this?


    • Not all of the trust’s assets are held in the allocated account. Read the bit on subcustodians. You have to read it carefully.

      Do I have to spell it out for you? This link, page 11.

      Besides, even if there was no “subcustodians” clause in the prospectus, the fund manager can run off with customer money like Corzine (MF Global) or Peregrine.

      The clause you cited does not exclude the possibility of rehypothecation. “Rehypothetication” is when the gold in the bank’s vault is pledged as collateral for other trades, or if the same gold bar is promised to multiple customers. You won’t find out about that fraud until the bank declares bankruptcy.

      If the bank that manages GLD goes bankrupt, one of the first things they will probably do is raid the GLD fund, leaving shareholders holding the bag. If you believe “Wait a minute, the CEO can’t flagrantly rob customers and shareholders!”, then you haven’t been paying attention.

      • According to this, the trust can’t even visit its own gold while in possession of a sub-custodian (or sub-subcustodian… or sub-sub-subcostodian).

        To be honest, I can’t understand how anyone in their right mind would buy shares in a fund that had its hands bound in such a fashion.

        • That’s just legal weasel words. In effect, the GLD and SLV funds are a variation of the classical fractional reserve banking scam.

          Even for a fund like PHYS, which claims to have full reserves, you don’t know if the fund manager will cheat you.

          A pro-State troll says “Those funds are audited!” Enron was audited. MF Global was audited. Lehman was audited. Being audited does not prevent fraud, especially when the CEO gets to choose the auditor!

          I predict that, sometime in the next 10-20 years, there will be a default on one of the big PM funds. If you read the fine print of the prospectus, the fund shareholders are stuck with the loss in the event of the loss. However, as long as the fund has more buyers than sellers, they can Ponzi it, and delay the default for awhile.

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