By Tom Bradley

There was an article in yesterday’s Globe on closed-end bullion funds that are trading at a premium to their underlying value (Why Pay a Premium for a Commodity). Unlike mutual funds, closed-end funds have a fixed number of units available (in the short term at least) and trade on the market like a stock. The fund price is subject to supply and demand. As a general rule, closed-end funds trade at a discount, but premiums do occur when a particular asset type, or investment manager, is in the spotlight, or when a fund is new and has been marketed heavily.

As the article explains, some of the premium may be the result of American buying. Apparently, there are tax advantages for U.S. investors who buy Canadian-domiciled bullion funds.

In any case, the premium amps up the volatility of an already speculative investment. And unfortunately, the increased volatility is all on the downside. To demonstrate what I mean, let’s assume that Jake is holding units in a gold fund that’s trading at an 18% premium (the highest of the ones mentioned in the article). Here are his possible outcomes:

1. Gold stays popular and rises in price. If the premium holds (18%), Jake will participate fully in the price increase.
2. Gold rises in price, but the premium shrinks due to new funds being offered or alternative vehicles being developed. Jake will benefit from the price rise, but only to the extent that it isn’t offset by the premium shrinkage. If the fund went back to trading at net asset value, gold would need to rise 18% (to $1,700) just for him to stay even.
3. If enthusiasm wanes and the gold price drops, it’s likely that the premium will disappear and instead turn into a discount. If gold went down 10% and the fund traded at net asset value, which would be a good result in a weak environment, Jake would be down 28%.

It’s possible that Jake could buy at a lower premium and see it rise (who would’ve anticipated 18%), but I’ve tried to cover the most likely scenarios.

There may be valid reasons why other investors are willing to buy an asset for more than it’s worth, but if those reasons are not relevant to you, don’t do it.

In general, there is money to be made in closed-end funds, but only by the most savvy of investors. It is an inefficient part of the capital markets where those who know benefit from those who don’t. It brings me back to an old analogy: If you’re playing poker and don’t know who the patsy is, it’s you.