PHYS: Not A Gold ETF, And A BAD Deal

I guess you know your town is on the map when the carnies show up and start taking the rubes.

Last week, the “Sprott Physical Gold Trust” started trading on the New York Stock Exchange under the ticker PHYS. Almost immediately, the media starting singing its glory: “New Gold ETF Prospectus Reveals Exciting Feature,” wrote Seeking Alpha contributor ETFdb. Invest with an Edge had similarly glowing coverage.

Unfortunately, PHYS is not an ETF. And its “exciting feature?” Well, that turns out to be a trap.

Not An ETF

I define an ETF as an open-ended mutual fund that trades on an exchange and uses a creation and redemption mechanism to keep its share price in line with its NAV.

PHYS trades on an exchange, but the comparisons stop there.

The company doesn't try to hide this. The prospectus states:

As a closed-end fund, PHYS comes with all kinds of warts that do not apply to ETFs. For starters, PHYS was sold at a 5 percent commission. That is, the price offered to initial investors in the fund was $10 a share, but the NAV took an immediate haircut to $9.50, because 50 cents went into the hands of the good folks at RBC Dominion Securities, Morgan Stanley Canada, BMO Nesbitt Burns and other underwriters. ETFs never come with initial underwriting commissions.

That might not matter to investors who purchase it on the open market, but there are other warts that do.

For instance, as with all closed-end funds, there is no way for PHYS to issue new shares, which means there is effectively no way for the security to actually track the price of gold. Sure, it might, but if the shares trade at a premium, it's impossible for an arbitrageur to go buy gold, turn it into shares, sell them on the open market and drive the market price back to NAV.

PHYS does have a redemption feature, but it's severely crippled. The PHYS redemption window is only open once a month, and it comes with a lag. Investors who want to redeem shares of the fund can submit a request to the company on the 15th of the month. If the redemption request is large enough (bigger than a single gold bar), the redemption will be processed at least in part for physical gold at NAV at the end of the month (13-15 days later). If you're redeeming lots smaller than a physical gold bar or just want cash, you get dinged for at least 5 percent off of the value of the fund.

That's not exactly a liquidity option. Let's just say that market makers aren't lining up to ride this “lightning-quick” 15-day flawed redemption process to ensure that the fund stays close to fair value.

The Big Tax Trap

But those flaws pale in comparison with the “exciting feature” that ETFdb notes in its article: the tax treatment.

According to the fund's prospectus, “Any gains realized on the sale of units by an investor … may be taxable as long-term capital gains (at a maximum rate of 15% under current law).”

It sounds like the Holy Grail. One of the vexing problems of funds like the SPDR Gold Trust (NYSEArca: GLD) is that, no matter how long you own it, you will owe 28 percent taxes on gains because the IRS considers all gold investments to be collectibles. PHYS claims to have found a way around this problem, creating a gold bullion fund that qualifies for true long-term tax treatment. Brilliant!

Except it's not.

The IRS isn't stupid. It's going to get its money somewhere. And in this case, it looks like it's reaching into the pockets of PHYS' most loyal, buy-and-hold investors to grab that 28 percent for the U.S. Treasury.

Understanding why gets into the weeds of the prospectus, but it's important to do, because the implications are huge. Here's the relevant paragraph:

Let me parse that for you.

You, Mr. Long-Term Buy-and-Hold, purchase shares of PHYS and stuff them deep in your portfolio, confident that you'll only pay long-term gains of 15 percent when you eventually decide to sell. Meanwhile, a hedge fund buys shares of PHYS, rides them while gold is rising, and then redeems them back to the fund company.

To meet this redemption, the trust either sells a pile of gold to pay cash or redeems out physical gold bars. Either way, the trust will book that sale with the IRS based on the current price as gold, and will be taxed at the 28 percent collectible rate on any gains. But funds never actually pay taxes: They pass them along to shareholders. So that 28 percent gain accrued by the hedge fund activity? That's going to be paid by you, even though you never sold a share.

I guess I'll have to agree with the headlines—that's certainly an exciting feature. I suppose getting a root canal without the gas is “exciting” too.

ETFs treat all investors fairly. PHYS not so much.

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ETFs Are Not Really Transparent

The concept of “transparency” in ETFs is so pervasive that people just assume it’s true. Look at almost any ETF provider’s Web site and you will see the word “transparency” highlighted as one of the key benefits.

If you go to www.ishares.com, for instance, you’ll find the following, right at the top of the page:

You can see similar messages at State Street Global Advisors, PowerShares, Vanguard and others.

But there is actually no rule requiring index-based ETFs to disclose their portfolios any more frequently than traditional mutual funds. And for many ETFs, portfolio disclosure is either incomplete or significantly delayed. And the problem is getting worse.

The Myth Of ETF Transparency

The myth of ETF transparency stems from the fact that ETFs must publish their “creation baskets” at the end of every day. The creation basket is the shopping list of securities—tickers and numbers of shares—an institutional investor (aka, an “Authorized Participant”) must deliver to an ETF issuer if he or she wants to create a tranche of new shares in an ETF. For instance, the creation basket of the SPDR S&P 500 ETF (NYSEArca: SPY) will likely contain all 500 stocks in the S&P 500 in approximately the same weights as those stocks that exist in the index.

Creation baskets are often extremely close to the actual holdings of a fund, but they don’t have to be. For large-cap domestic equity ETFs, they’re usually identical. But as you move into less liquid areas of the market, a significant gap can develop between the contents of the creation basket and the holdings of the underlying fund, all the way until they are so divergent that the ETF issuer just asks for cash.

Take the iShares MSCI Emerging Markets ETF (NYSEArca: EEM). Due to an index licensing issue with MSCI, iShares only discloses the full portfolio for EEM on its public Web site on a month-end basis. As of March 1, 2010, the last portfolio holdings data available was as of Jan. 29, 2010.

If you have access to a Bloomberg machine (costing >$20K/year), you can see the full portfolio. I imagine if you picked up the phone and talked to someone at iShares on any given Tuesday, they’d probably fax it to you as well. And what you’d find is that the actual holdings differ significantly from the creation basket.

We’re not talking small differences here. Samsung has almost a half-percent bigger role in the creation basket than it does in the ETF. The reasons for these discrepancies aren’t nefarious—they’re common sense. The basket is simply smaller, ignoring the least liquid, hardest-to-buy securities. One assumes that those securities might be purchased in a later basket, if the manager really felt they needed them for tracking purposes. But in general, the basket is optimized to be “easy to buy” for the AP. That’s a good thing, because an involved AP means lower spreads on the ETF itself.

Most iShares—indeed most ETFs—provide full portfolio-level disclosure on their public Web sites on a daily basis. But some, like EEM, have halting disclosure at best.

A Worse Case: ProShares

ProShares’ family of leveraged ETFs is another example of imperfect disclosure. ProShares ETFs hold swap arrangements as their core asset. Swaps are privately negotiated contracts whereby two parties agree to exchange a pattern of returns. In the case of ProShares, it will agree with a bank to deliver anywhere from 200 to negative 300 percent of the daily return of a benchmark index.

These arrangements generally work well, but they do come with some measure of credit risk for investors. If one of the underwriting banks were to go bankrupt, shareholders could lose money (although usually not more than 5-10 percent even in the worst-case scenario).

ProShares is not required to disclose the counterparties of its swaps, and it chooses not to do so.

Full transparency? Not really.

The Worst Offender: Vanguard

Vanguard is by far the worst offender on the transparency front. Vanguard refuses to disclose its portfolios on anything approaching a daily basis. In fact, it treats its ETFs just like mutual funds: It only discloses their portfolios every 90 days, and even then it applies a 30-day lag. Right now, for instance, the most up-to-date holdings information you can get on any Vanguard ETF (and this includes both public and Bloomberg data) is as of Dec. 31, 2009.

The Vanguard problem is made worse because it optimizes its creation baskets (which, by law, it does disclose), so that they represent very narrow windows on a fund. For instance, the Vanguard Total Bond Market ETF (NYSEArca: BND) had 4,219 holdings as of Dec. 31, 2009, but its creation basket is typically less than 50 securities.

Index Transparency Vs. Fund Transparency

ETF advocates would tell you that the lack of true fund-holding transparency doesn’t matter, since ETFs track indexes and you can always see what’s held in the index. ProShares uses the phrase “index transparency” to describe its ETFs, which is accurate.

But as covered recently on our site, ETF tracking error has exploded, with wide gaps opening up between index and ETF performance.

I love the idea of ETFs being “fully transparent.” And most of them are, with complete portfolios published on provider Web sites on a daily basis.

But an increasing number of ETFs fail the test. The ETF industry should commit to true transparency, from Vanguard to ProShares to everyone in between.

(Ironically, actively managed ETFs—unlike their index-based cousins—must disclose their full portfolios on a daily basis. Who knew that actively managed funds could be more transparent than index products?)

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Finding Yield In A Haze Of Smoke And Mirrors

Our new managing editor, Olivier Ludwig, is fond of saying: “Boy, I’m glad I’m not 65 right now,” and I’m inclined to agree with him. After all, the days when you could find some CD paying 10 percent and just forget about it are long, long gone. If you’re looking for actual income—as in, you genuinely want to be getting a check every quarter that you use to pay for your condo in Florida—your options are pretty limited.

But then again, how can you even know what the options look like? Let me pick one line item out of Matt’s last blog on the WisdomTree Pacific ex-Japan Equity Income Fund (NYSEArca: DNH). In the table (which is straight off Bloomberg), DNH reports an “Average Dividend Yield” of 7.02 percent. Sounds great right? That means if you stick a million bucks in DNH, you should be getting a $70,000 check every year, which in this environment, doesn’t sound too shabby.

Not so fast.

First, remember that when we’re dealing with dividends, there is no free lunch, and no guarantee. Dividends can vary wildly from quarter to quarter within the same industry and even the same company. First, these turbulent economic times have been rough on corporate earnings, and earnings are what translate into dividends. Sure, some companies stick to their dividends through thick and thin (Home Depot’s slow and steady dividend growth is the stuff of legend, even while earnings slid disastrously in 2009).

But even then, how do you know what that “7 percent” number really means?

Luckily, WisdomTree does a great job of explaining this, while showing you ALL the ways you could interpret yield. Here’s what they currently report on their Web site for DNH’s yield:

Fund Distribution Yield: 3.75%

SEC Standardized 30-Day Yield: 4.56%

Portfolio Gross Yield: 7.05%

Portfolio Net Yield: 5.92%

Those are some pretty big swings, but understanding them is key to having a no-surprises relationship with your income-generating investments. Let’s just walk through the list.

Fund Distribution Yield is simple, and perhaps the most useless measurement. It takes the very last distribution the ETF made to the ETF shareholders, and annualizes that, based on the current price. If the fund is trading at $100, and the last quarterly dividend was a dollar, it will assume that 1 percent gets kicked out every quarter and roll it up into a 12-month yield of 4 percent. Of course, there is no guarantee that future dividends will be anything like that very last one. In the case of DNH, the number can vary pretty wildly. The 24-cent dividend in 2009’s first quarter grew to almost twice that in the fourth quarter. Some companies also do one other little piece of math for you, and calculate the trailing 12-month fund distribution yield, which is just the last 4 quarterly dividends divided by price. That’s usually just reported as 12-month yield.

SEC Standardized 30-Day Yield gets a little closer to something we care about. It reports an annualized measurement of the actual earnings of the fund itself over the previous 30-day period, after expenses. It’s still a rearview mirror, but it’s one based at least marginally on the portfolio reality.

Gross and Net Portfolio Yield are just a little more interesting. The Gross Yield is calculated by looking at the trailing 12-month history of each and every holding in the fund, and simply comparing that with the holding’s current price. The weighted average is what’s reported, which is, in this case, that magic 7 percent number. The net number is what the fund would have actually collected of that yield, after foreign governments have collected their taxes. For a fund with just U.S. investments, the numbers are identical.

So what’s an investor to do? Historically, the best bet is to look at the SEC 30-Day Yield and the Portfolio Net Yield. Your actual forward experience is likely to be somewhere in the range between the two. And if you’re confused by all this uncertainty, well, that’s why there’s a bond market, or, as some folks call it, “FIXED Income.” Fixed, that is, if you buy one bond.

Bond funds? That’s a story for a different day.

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High-Yield ETFs May Make Your Hands Dirty

Let’s be honest: With bank accounts paying zero and the S&P 500 yielding peanuts, investors are looking for yield. And to get yield in these markets, you have to get your hands a little dirty.

If you run a sort on the highest-yielding ETFs right now, you come up with this list:

As noted, the PowerShares ETF you ravaged in your blog yesterday promises an early-indication yield of about 8.5 percent. That ties it for second place among the highest-yielding ETFs at the moment. To earn a higher yield, you’d have to plow your money into the iShares FTSE NAREIT Mortgage Plus Capped ETF (NYSEArca: REM), which yields 9.11 percent currently.

REM invests in companies that hold residential mortgages, mostly those underwritten by government-sponsored entities like Fannie Mae and Freddie Mac. Its largest holding at more than 22 percent of the portfolio, Annaly Capital, describes its business as follows:

Not only residential mortgages, but leverage! No wonder the fund has lost about 70 percent of its value since its launch in the first half of 2007.

I like beaten-down funds as much as the next guy, but with the government likely to end its housing stimulus plan soon, unemployment still at 10 percent and Congress loath to give more funds to Fannie and Freddie, I might rather place my bets on the closed-end fund.

I’ll admit this, though: When you move beyond REM, you start running into some interesting funds. Who knew that the underlying companies in the WisdomTree Pacific Ex-Japan (NYSEArca: DNH) ETF were yielding close to 7 percent? That’s not bad at all.

In the end, I don’t love closed-end funds either, Dave. In fact, I dislike them more than you do. To me, the real reason they exist is so brokers can sell them on commission. And honestly, I find that unconscionable. Investors regularly cough up 5 percent commissions to buy new CEFs that they could instead buy the next day at fair value or at a discount. Any adviser who recommends buying a CEF and paying a commission is doing their customer a disservice.

PCEF at least avoids this problem. And by only buying funds already trading at a discount, I’m not as sour on it as you appear to be.

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PCEF: Powdering The Pig

ETFs are all about transparency, right? Complete, X-raylike vision into your holdings. They’re touted as being (and are) better than mutual funds, in part because that transparency is effectively continuous and in real time. You not only know what you own, but the market tells you what that’s really worth with no delay.

Mutual funds, by comparison, muddy the water a bit: You get biannual or quarterly disclosures of your holdings, usually with a 30-day lag. On the upside, you get fair pricing: Every mutual fund can be redeemed at net asset value, every day, after the close of trading. Closed-end funds (CEF) muddy that not-all-that-clear tap water even more. Not only are the holdings obscure, but at any given time, the funds are not necessarily worth what you think they should be worth.

A CEF trades intraday on an exchange like an ETF, but there’s no arbitrage mechanism to keep the market price anywhere near in line with the actual underlying investments. As a result, closed-end funds trade all over the place, with premiums and discounts well into the double digits, based solely on market demand for the CEF shares themselves.

As Cinthia covered on Friday, the new PowerShares CEF Income Composite Portfolio (NYSEArca: PCEF) tries to make a kind of Reese’s Peanut Butter Cup out of a handful of closed-end funds by packaging them into an ETF wrapper. In fact, it tries to take advantage of the very flaw in CEFs I outlined above, by systematically underweighting those CEFs that are a rip-off (trading at a premium) and overweighting the ones nobody wants (trading at a discount). Sorry, did I just tip my hat there on my opinion of closed-end funds?

The only reason CEFs really exist is to take advantage of a single fact: Their portfolios are fixed. Once a CEF raises its initial capital, it can enter into long-term contracts, employ leverage, even issue secondary securities to raise additional (levered) capital to its heart’s content, without ever having to worry about a redemption. If investors don’t like what the manager is doing, they’ll sell the shares to a discount. If everyone’s a believer, they bid shares up to more than they are worth. It’s a great deal for fund managers: They can still charge 1 percent or more of the funds’ net asset value, with zero market accountability.

There’s still some accountability—CEFs are regulated mostly just like mutual funds. They’ve got boards with fiduciary responsibility, and for the most part, are just as good or bad citizens as the rest of the industry. The problem is that the structure isn’t inherently all that investor-friendly (I await the angry email from the Closed-End Fund Association.)

Just like mutual funds, you’re stuck with six-month disclosure frequency (with delays), and arcane reports at that. Just like ETFs, you’ll pay a commission and a brokerage fee to buy and sell. You’re also subject to the whims of the market in terms of premiums and discounts. They effectively take the worst of all possible worlds—zero transparency, high cost and unreliable pricing—just for a little bit of manager flexibility.

And now, PowerShares is wrapping them all up in a bow for us. At least, I think it’s a bow. As of this writing, while there is a prospectus available, it’s one of the thinnest I’ve ever seen. There’s no detailed discussion of what the underlying CEFs are actually being selected to do, no detailed discussion of the underlying index, where it comes from, or its past performance. There are no hypothetical return scenarios.

It’s about as boilerplate as it gets. There’s no fund fact sheet available. There’s no link to the index on the PowerShares Web site (I’ll give you one), and even when you get there, there’s no index data past 9/14/2009.

This is all actually odd, given that according to Bloomberg, the index (The S-Network Composite Closed End Fund Index) has kicked the pants of the S&P 500 in the last year and change.

The underlying concept here is actually interesting to me—buying fixed-income assets through a structure that historically trades at a discount in order to capture higher yields. It’s a shame you have to wade through so much mud to get to the core.

And did I mention for all of this you'll pay upward of 1.8 percent in expenses, all in?

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The views expressed by those blogging are for informational purposes only and should not be construed as a recomendation for any security.