Investing With Jay Today

February 1, 2009

Central Fund of Canada (CEF)
 and Arbitrage

QUESTION FROM A READER: Would a purchase of Central Fund of Canada (CEF) be the equivalent of SLV and GLD? If so, would you have a preference?

ANSWER: Since there is no way to answer this question in a sentence or two, or even in a paragraph or two, without confusion, I decided to write an essay long enough to cover all the points as clearly as I can make them. It won't be perfect, but I'll do my best.

BACKGROUND: Central Fund of Canada (CEF) was founded in 1961 by a group of sound money advocates for the sole purpose of providing investors with the easiest way possible to acquire the soundest form of money possible. In my opinion, they have accomplished their goal. Over the 47 years of its existence, the acceptance of and respect for the fund by the sound money community has steadily increased. The fund is a closed-end mutual fund which trades in the US on the New York Stock Exchange (symbol CEF), and in Canada on the Toronto Stock Exchange (symbol CEF.A). Its only assets are gold and silver bullion held in a segregated custodial account in a Canadian bank, and a small amount of cash or other assets (about 3%) used for expenses of operating the fund. To save many paragraphs in this essay, I urge you to go to the fund's web site ( and read everything on it, if you have any interest in investing in it.

Other than holding physical gold and silver (coins or bars) in my own possession, I consider CEF the safest and easiest way to invest in gold and silver. I must quickly add that there are times when I prefer it even to my own physical possession of the precious metals because of the trading and arbitrage opportunites it offers (to be explained momentarily). 

Obviously, then, I prefer it over SLV and GLD, but only when conditions are right, which I am about to explain.

TAXES: If you are going to use CEF to take advantage of trading or arbitrage opportunities, you will want to buy or sell it in a tax-deferred account such as an IRA or 401K. Otherwise you will be creating a taxable event every time you sell it, which will eliminate all or most of the benefits. Also, you will not want to trade small amounts of capital, as the spreads on the trading and arbitrage opportunities will not justify the efforts. The two best vehicles I am aware of are the SEP IRA and a self-administered one-participant retirement trust. (not difficult to establish and roll retirement money into).

CLOSED-END V. OPEN-END. The first thing you need to understand is the difference in a closed-end and an open-end mutual fund. Probably 95% of all mutual funds are open-end. They trade once per day following the close of the markets. Both buys and sells are executed at the exact net asset value per share based on the day's close. The net asset value is calculated by dividing the total market value of all assets in the fund by the total number of shares of the fund. If more shares are bought than sold on a given day, new shares are created for the net difference. Likewise, if more shares are sold than bought, the total number of shares is reduced by the net difference.

By contrast, the closed-end mutual fund trades on the stock exchange all day long exactly like all other stocks on the exchange. The total number of shares stays the same. The shares sold simply move to new buyers, but the total number of shares remain the same. The share price varies all day long and depends on supply (number of shares being offered for sale) and demand (number of shares being bid on for purchase), like all other stocks. 

IMPORTANT: Thus, the share price of a closed-end fund can vary both below and above the net asset value depending on whether buyers or sellers have the "upper hand" (i.e. buying pressure versus selling pressure). This is what creates trading and arbitrage opportunities. For example, over the past few months, the market price of CEF has ranged from a premium of 5% over its net asset value to a premium of 22% over its net asset value. Therefore, I do not buy CEF unless I can get it at a premium of 5% to 6%. I do not sell it unless I can get a premium of 18% to 20%.

HOW TO CALCULATE THE PREMIUM: The CEF web site quotes a premium every day following the market close. It's not useful in my trading for two reasons, (1) the market is already closed so you can't do a trade, and (2) It includes the non-precious metals assets in the fund. I'm only interested in paying 5% to 6% over spot price for the actual gold and silver I'm getting. Here's a sample calculation I use when I want to make a trade.

CALCULATING THE GOLD AND SILVER VALUE OF ONE SHARE OF CEF: This is really quite simple. I use a simple Excel spreadsheet to calculate it. You can do it on a hand calculator. There are two constants you use and three items of input. The two constants are .006361 (the number of ounces of gold in each CEF share), and .318006 (the number of ounces of silver in each CEF share). Note: These numbers are easily calculated from the total number of shares of CEF outstanding, and the total ounces of gold and silver held by the fund as reported on the Net Asset Value link on the web site. Here are the three input items:

1. The last trade on CEF. My quote update tool bar in Excel gets this in an instant. For an illustration, we'll use last night's close on the NYSE, which was 11.15.

2. The last spot price of gold (I get this from Kitco's K-Cast). Last night's close was 927.

3. The last spot price of silver (from Kitco). Last night's close was 12.67.

Now we're ready to calculate the gold and silver value (at spot) of one share of CEF: 

(.006361)(927) + (.318006)(12.67) = 9.926

This is the gold and silver value of one share of CEF as of last night's close. Compare this to the closing market value of 11.15, and you can see that the premium was 12.33% (11.15 divided by 9.926 = 1.1233)

This information tells me that CEF is neither a good buy nor a good sell, i.e. the premium is neither under 6% nor over 18%. Thus, if I own it I won't sell it, and if I don't own it, I won't buy it. I will wait for the next opportunity.

The next piece of the puzzle is the key to the whole project. That brings us to the word "arbitrage."

WHAT IS ARBITRAGE? In investment circles, the word as a noun means "a difference" or a "spread." As a verb, it means "to capture a spread." A particular asset sells in a given market (or form) at a particular price, but at the same time sells in a different market (or different form) at a different price. Thus, you can "arbitrage" the difference by selling that asset at the higher price and simultaneously buying it in the other market at the lower price. If the difference is meaningful, the two trades will produce a profit with no cash outlay, and zero risk.

Let's follow on with our illustration above. If I were satisfied with the 12.33% premium CEF was selling at (above its gold and silver value), and I owned CEF, I could have sold it, then re-invested all the proceeds of the sale in 1-oz gold bars at 3% over spot (which were available yesterday), thus capturing a spread of about 9% of the value of the CEF sold. By putting in a simultaneous market buy and market sell order, and clicking the trade buttons within 5 seconds of each other I could have increased my gold and/or silver value in my CEF stock by about 9%, with zero risk and zero cash outlay.

A KEY CONCEPT TO UNDERSTAND: Arbitraging has nothing to do with my allocations, whether or not I want to hold gold or silver long term, etc. It is simply a way of increasing my holdings with no cash outlay and no risk. I still have the risk of owning gold and silver, or any other asset. This has nothing to do with that. Separate it in your mind.

QUESTION: ARE YOU SAYING YOU CAN GET SOMETHING FOR NOTHING, AND IF SO, HOW CAN THAT BE? That's a logical question, with a very logical answer. If it were obvious and simple, the opportunity would not exist. If the great mass of investors were aware of spreads, the market would quickly take the opportunities away.

ARBITRAGEURS: One rare type of investor is called an "arbitrageur." He searches, studies and waits and waits and waits for a spread to show up, then jumps on it. He is seeking to compound his asset base over time without additional risk or cash outlay. Of course, he always has risk in whatever asset he is arbitraging. When I began to see spreads develop in gold and silver assets, it occurred to me, what asset class could be better to arbitrage than gold or silver? I don't know how long these opportunities will last (not likely too long), but why not take advantage of them as long as possible? Here are some arbitrage ideas I have already done or hope to do in the future. The ones already done were very profitable, each with no cash outlay.

  1. Having bought CEF at a 5% premium above its gold/silver value, I was able to sell it at an 18% premium, and re-invest the total proceeds in 1-oz gold bars at 3% over spot. At the moment, I have no CEF, but I will be a buyer at 5% to 6% premium as stated above. If I don't want to change my gold/silver allocations, I will simultaneously sell something to offset the purchase, then wait for the arbitrage opportunity.

  2. I sold some of my junk (90%) silver coins (which I had held several years) at 30% over spot, and reinvested all the proceeds in silver futures at spot. I subsequently took delivery of my silver futures in 1000-oz bars.

  3. I sold more junk silver coins at 12.50 per ounce, and reinvested the proceeds in the Royal Canadian Mint silver pool at 10.00 per ounce.

  4. I own some silver eagles. If they get back to a 20% premium over spot, I will sell some and reinvest either in a silver future or SLV at spot.

  5. I also own some gold Kruggerrands. If they rise to a high enough premium over spot, I would consider arbitraging them with 1-oz gold bars or GLD at spot.

CLOSING THOUGHT: The more volatile and chaotic the markets become, the more likely arbitrage opportunities are to arise. Any good arbitrage opportunity is worth waiting for. Do your calculations carefully and check them, making sure your spread is assured before you simultaneously enter the buy and sell orders, and make sure there is no cash outlay required (or an insignificant amount. You can't hit it to the penny).

I hope this will answer questions which some of you may have, and that this information might be of value to some of you.

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"Well done, good and faithful servant; you were faithful over a few things,
I will make you ruler over many things.  Enter into the joy of your lord"
(Mt. 25:21 NKJV)

If you have not been faithful in the unrighteous mammon, who will commit to your trust to true riches?" (Lk. 16:11 NKJV)

The Apostle Paul wrote, "Now godliness with contentment is great gain. We brought nothing into the world and it is certain that neither can we take anything out. So having food and clothing we will be content with that. But those who want to get rich fall into temptation and a snare and into many foolish and harmful desires, that plunge people into ruin and loss; because the love of money is a root of all kinds of evil; in their greediness some have been led away from the faith and have impaled themselves on many distresses." (1 Tim. 6:6-10 NKJV)

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The information in this article is the responsibility of Jay O'Keefe, but all your decisions are your own responsibility.

This web page was last updated on 18 February 2009 .