When Morgan Stanley launched its first closed-ended fund in India in 1994 (Morgan Stanley Growth Fund), few investors understood concepts like mutual fund NAV or closed ended mutual funds. The IPO of MSGF (only later the name was changed to NFO) attracting millions of investors. Being a closed-ended fund, it would be traded on the stock exchanges. But people missed two things. Unlike an IPO, the mutual fund NFO starts trading at a discount to the NAV of ₹10 per unit, since costs are adjusted. Secondly, closed ended funds trade at a discount to the NAV. People bought units in the informal market at exorbitant premiums and were shocked to see the fund listing at a discount. 

Like in the MSGF in 1994, the silver ETFs was also a classic case of inadequate grasp of the product. For instance, an ETFs is pegged to the underlying price of the metal (silver in this case). Hence, the actual NAV can be at a small discount or small premium to the price of silver, but it cannot trade at a premium of 14-18% on the spot price. That is what happened in the case of silver ETFs. The demand for silver ETFs was very strong and the supply was limited. This created a scarcity value for silver ETFs, leading the silver ETFs to trade at huge premiums in the market. It is these premiums that we saw unwinding. 

During the last week, the markets on Thursday saw silver spot prices fall by around 2-3%, and the NAV of these Silver ETFs also fell by a similar margin. However, the price of the silver ETFs in the market fell by as much as 14%-18%. What explains this dichotomy? The reason was the froth built up in the ETF price due to the scarcity factor in the market. In fact, the ETF price reflected less of fundamentals and more of surplus demand over supply, which is what made the price frothy. However, it missed the fundamental story that in a passive fund the price has to reflect the underlying commodity, with some minor discrepancies, at best. That is what caused the sharp correction only in silver ETFs. 

What happened to silver ETFs in the last one week is a good lesson for ETF investors. Remember, when you are investing in any passive asset, the idea is to just reflect the price of the underlying asset, silver in this case. So, there could be a minor discount or premium, which is understandable. However, if you buy silver ETFs at a huge premium to the spot price, then you are paying for froth. That is what investors must be cautious about. Secondly, be cautious of any major disconnect between the ETF price, the NAV, and the underlying price of the metal. That is a red flag. Always remember the basic rule of investing; if something is too good to be true, then it is most likely untrue!