Canadian Investors: Read This Warning Before Investing in a Gold or Silver Fund

There are plenty of reasons to prefer a gold or silver fund over bullion. You can hold it inside a registered account such as a Tax-Free Savings Account (TFSA). You can buy and sell it through your brokerage with a tight bid-ask spread, often narrower than what you would get from a precious metals dealer. And you do not have to worry about storage, insurance, or security.

But not all gold and silver funds are structured the same way. Some of the most popular names that show up first in a search are not necessarily the most efficient vehicles. In particular, there are structural reasons to consider a gold or silver exchange-traded fund (ETF) over a closed-end fund (CEF). Here is why that distinction matters.

Understanding CEFs

Consider two well-known examples: the Sprott Physical Gold Trust (TSX:PHYS) and the Sprott Physical Silver Trust (TSX:PSLV).

Both are physically backed. They hold gold and silver bullion in custody, audited and stored securely. When you buy units, you gain fractional exposure to actual metal. On the surface, that sounds ideal.

The issue is not what they own. It is how CEFs behave in the market. CEFs have two values. The first is the market price, which is what you see on your brokerage screen. The second is the net asset value, or NAV, which represents the true value of the underlying bullion per unit. Those two numbers are not always the same.

Because closed-end funds have a fixed number of units outstanding, their market price can trade at a premium or discount to NAV depending on investor demand. As of February 20, for example, PHYS was trading at a roughly 2.5% discount to its NAV, while PSLV was trading at an even wider discount of nearly 4%.

At first glance, that may seem attractive. You are buying gold or silver for less than its underlying value. But there is no guarantee that discount will close. It can persist for years. It can widen further if sentiment shifts and investors rush to sell.

The opposite can also happen. During periods of enthusiasm, these funds can trade at a premium to NAV. That means you are paying more than the underlying is worth. If that premium later disappears, you can lose money even if gold or silver prices remain stable.

Why ETFs are better

Closed-end precious metals funds can trade at persistent premiums or discounts to their underlying bullion value. Like CEFs, ETFs also have a market price and a NAV. But ETFs are open-ended. Behind the scenes, authorized participants can create or redeem large blocks of ETF shares in exchange for the underlying bullion.

This in-kind creation and redemption process creates an arbitrage mechanism. If the ETF trades above NAV, authorized participants can trade bullion to create new shares and sell them, pushing the price down. If it trades below NAV, they can buy shares and redeem them for bullion, pushing the price up.

That arbitrage incentive helps keep ETF market prices tightly aligned with NAV. The gap rarely persists for long and is usually very small. CEFs do not have this built-in mechanism. That is why discounts and premiums can linger or become exaggerated.

If you are buying gold or silver for portfolio insurance or long-term diversification, structure matters. The metal exposure may be identical, but how the fund trades can meaningfully affect your return.

The post Canadian Investors: Read This Warning Before Investing in a Gold or Silver Fund appeared first on The Motley Fool Canada.

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Fool contributor Tony Dong has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.