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Wanna Hedge? Think Silver Not Gold

Gold may be in vogue, but silver could be a better investment today in relative terms.

Paul Justice, 11/23/2009

Investor interest in gold is reaching multi-decade highs as the price of bullion is also attaining new highs. Many view gold as an effective diversification tool to offset inflation or weakening currency value concerns. However, it's usually best to purchase insurance when it's cheap. With that thought, we think gold's highly correlated but less prominent cousin, silver, may be a better investment today in relative terms.

While it's true that silver has been more volatile and has appreciated more in value than gold over the past year, it has not yet reached the pricing highs it attained just three years ago. Furthermore, it has lagged gold's price performance over the last two years. For investors willing to take the risks, we think that iShares Silver Trust SLV may be the better hedge of the two today.

For most investors, owning precious metals like silver makes sense as a hedge against the loss in purchasing power of paper currencies. Governments have historically been lousy stewards of the value of their currencies, and a precious metals position can help hedge a portfolio against such losses. Of course, investors may also wish to directly speculate on silver prices, and this would be an investment vehicle with which to do that.

However, it should be noted that silver isn't a foolproof inflation hedge. Unlike gold, silver has industrial applications, which means it's more likely to fluctuate with economic ups and downs. If companies that use silver in their manufacturing process produce fewer products, silver prices--and this ETF--are likely to suffer. More importantly, over the long haul, precious metals haven't returned much more than inflation. Historically, stocks have offered better protection against inflation.PAGEBREAK

That said, this fund can be used periodically as a satellite holding. It represents a direct investment in the underlying commodity and does not invest in equity securities or futures contracts. Unlike equities or bonds, commodities are non-earning assets that are worth only what another party is willing to pay. However, commodities in general offer diversification benefits that can traditionally be reaped when other securities markets are performing poorly. When considered as a long-term core holding, we would recommend using this fund only up to a weighting of 1%-2% of total assets, if at all. Our research suggests that a 4%-10% total weighting for all direct commodities exposure is sufficient, and the majority of that weighting should be split among energy, agricultural, and industrial and precious metals.

Investing in silver isn't a priority for everyone, but it has some valuable uses in a dollar-based portfolio. For one, it's a good hedge against inflation and the dollar, as the two tend to have an inverse relationship. That is, when the dollar gets weaker, precious metals are generally going up, because it's a limited commodity that retains purchasing power even when price inflation ratchets up. Conversely, when the dollar is strong, silver's value decreases because you may be able to get more bang out of the greenback than from the precious metal. And, because precious metals are generally uncorrelated to how stocks and bonds move, it can serve as a good diversification tool in your portfolio. Finally, unlike paper currencies, silver isn't at the mercy of government policy. Because it's not something that can be easily issued or mined, you won't see its value decrease overnight as you may if the government suddenly decides to pump up the circulation of currency in the market.

Portfolio Construction
Unlike most ETFs, this fund does not track an index. Instead, the fund directly owns silver bullion, held at the London branch of J.P. Morgan Chase. Its price will reflect the market price of one ounce of silver, less the expenses of the fund. Under current tax laws, gains on this investment are taxed the same as collectibles (same as ordinary income rates), at a maximum of 28%, regardless of an investor's holding period. Despite rumors from conspiracy theorists, this fund actually holds physical silver in vaults to back up its shares. At the time of this writing, more than 280 million ounces of silver that are undeniably allocated to this fund's shareholders are stored securely under the streets of London. No additional shares of this fund can be produced by cash or derivatives contracts. Authorized participants are issued shares in exchange for physical quantities of silver. The only violation to this process is a three-day waiting period from the time of share creation until the physical commodity is delivered.

Fees
This fund levies a 0.50% expense ratio, which is on par with other precious-metal ETFs, though it's less than half the cost of the typical open-ended mutual fund.

Alternatives
The closest competition to this fund is the newly issued ETFS Physical Silver SIVR, which has a nearly identical structure and charges just 0.30% per year (the fee may go up to 0.45% per year in the summer of 2010). Given that SLV has over 25 times more assets under management, we would choose this fund over the competition if silver is our target exposure. Investors trying to get a piece of the action in the commodities space may opt for a more broadly diversified commodity fund, such as iPath Dow Jones-AIG Commodities DJP. For a 0.75% fee, investors gain diversified exposure to 29 different commodities, including energy, agricultural, and metals. However, the fund is structured as an exchange-traded note and thus leaves investors exposed to credit risk from Barclays. PowerShares DB Commodity Index Tracking DBC also charges 0.75%, but it uses a smaller sampling of six commodities and is more heavily weighted toward energy. However, it is structured as an ETF and thus minimizes the credit risk that is inherent in an ETN.

Paul Justice is an ETF strategist with Morningstar and a contributor to Morningstar's ETFInvestor newsletter.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

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