APRIL 23, 2011.

Hi Ho, Silver: Some Fund Investors Could End Up Tarnished

By JASON ZWEIGLike this columnist ..

Does every silver cloud have a dark lining?

Few assets have been hotter lately than silver, which has gained about 160% over the past year. So far in 2011, four major funds that specialize in the gray metal—iShares Silver Trust, Sprott Physical Silver Trust, ETFS Physical Silver Shares and PowerShares DB Silver Fund—are up between 50% and 59%.

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Christophe Vorlet
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The iShares fund has tripled over the past year, to $16.6 billion. It is now the 12th-largest exchange-traded fund in the U.S. and holds about one-third of all the silver bullion on earth.

Money always chases performance, but when returns get this glittery, the chase becomes a frantic sprint. This week, the half-dozen silver ETFs commanded more than $20 billion in assets, up 23% in three weeks. Nearly 90 million shares of the iShares fund—roughly a quarter of its total capitalization—traded this past Wednesday alone.

In the panic to buy a silver fund before the metal goes up even more, investors may be overlooking some of the fundamental oddities and potential risks of these funds.

Take the Sprott fund, which is in such hot demand that buyers this week were paying $1.22 for every dollar's worth of silver in the portfolio.

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Reuters

Investors are chasing silver. Pictured here, bars on display at a Vienna plant.
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Sprott, based in Toronto, is structured as a closed-end fund. Because the manager doesn't issue new shares, anyone who wants to buy into the fund must buy from another shareholder on the open market. At last count, the silver in the fund was worth $18.15 a share—but the market price of the fund's shares was $22.11, a 22% premium over their net asset value.

Why would anyone pay $1.22 on the dollar for an asset that has already delivered blinding returns?

For one thing, buyers seem attracted to Sprott's unusual storage mechanism. The fund keeps its silver ingots at the Royal Canadian Mint. To many of the folks who buy precious metals as a hedge against financial catastrophe, that seems like a safer haven than the basement of a commercial bank—where most other funds store their silver.

Also, big holders of the Sprott fund can redeem their shares to Sprott for solid bars of pure silver—a comfort in a world of currencies that are becoming cheesier by the day.

Furthermore, Sprott offers an unusual tax benefit: If, when you file your taxes for the year you bought the fund, you append an obscure Internal Revenue Service document called Form 8621, then your future capital gains from selling the Sprott fund will be taxed at just 15%—the same rate you pay on a conventional stock. It is rare to get such a good tax deal on a holding in the commodities market.

But investors might wish to dig deeper.

In a filing with the Securities and Exchange Commission this week, Sprott registered to lift the sale restrictions on the 26% of the fund's total shares (or "units") that the manager bought for its own accounts at $10 apiece when the fund opened last November. Until now, those shares have been held off the market by chief executive Eric Sprott and several affiliates of the firm.

A person familiar with the operations of the fund said that Mr. Sprott was on vacation this week and that the sale, if any, of these shares would be at Mr. Sprott's discretion.

However, now that the registration has been filed with the SEC, they can be sold at any time, which would increase the number of the fund's shares available to trade and could depress the price.

The alluring option of redeeming Sprott units for silver applies only to investors who hold at least 25,786 units at today's prices, according to the person familiar with the fund. Yes, you could get a Brink's truck to pull up in front of your house with a glittering haul of silver when you sell the fund—but only if you held $600,000 or more. There are far easier and cheaper ways to buy silver.

As for the special tax treatment on Sprott, it applies exclusively to investors who make the required IRS filing. Otherwise you could owe back taxes at ordinary-income rates, plus interest. "If you do it wrong, you're really screwing yourself up," warns Robert Gordon, president of Twenty-First Securities Corp.

The other silver funds, like most commodity ETFs, are no tax bargain either. If precious metals stay hot, then your future capital gains will generally be taxed at 28% in the iShares and ETFs funds and at an effective rate of 23% in the PowerShares fund.

In the real world, not many people think of silver as a metal that gets too hot to touch. In the financial world, it seems to be getting hot enough to give unwary investors a scalding.

— intelligentinvestor@wsj.com; twitter.com/jasonzweigwsj

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