PureFunds has a simple strategy: Be first in the market with innovative exchange-traded funds. Andrew Chanin, PureFunds' co-founder and COO, describes the firm's ISE Junior Silver ETF and the factors that make a "leveraged play to the actual spot price of the metal." In this interview with The Gold Report, Chanin goes on to list some of the names included in the fund and explains how they contribute to its success.
The Gold Report: In August, the most active contract in the silver futures market had its best week in five years, and your PureFunds ISE Junior Silver Exchange-Traded Fund (SILJ) traded higher. What should silver investors expect through the end of 2013?
Andrew Chanin: In one word: volatility. However, I think the long-term trend for silver is an upward pattern. The fundamentals for silver and other precious metals look very bullish for stock prices in the coming months.
TGR: You started this silver junior exchange-traded fund (ETF) in late November 2012. Why then? Why silver?
AC: My partner Paul Zimnisky and I have wanted to launch a junior silver ETF for a long time. We see silver as an essential commodity for many purposes. It has incredible industrial uses as a conductor of heat and electricity. It has many medical and surgical applications, as well. On top of that, we've seen an undeniable increase in investment demand for silver.
I like to look at the demand for silver as a pie chart, in which many of the wedges of the pie—industrial investment, jewelry, monetary—are fighting to take up more of the total supply representing the whole pie chart. However, it's very difficult to meet increasing demand when you don't have increasing supply.
For example, production in Mexico in H1/13 looks to be down 10%, and Mexico is as essential to the silver production and supply equation as any region.
In addition, many producers were operating at a loss when their cost of getting an ounce of silver out of the ground was higher than the prevailing spot price of silver.
These issues paint a very ominous supply-side picture, while we continue to see record demand for U.S. silver eagle coins. In India, demand increased massively between April and July. This shift in the supply-demand curve makes it appear that demand may sharply outpace supply in the near term and beyond.
TGR: Do those two demand drivers—investment and industrial—make silver the trade right now?
AC: I believe strongly in silver. Precious metals tend to correlate with each other, so it's important to look at the sector as a whole. Historically, silver has tended to be a beta play on gold. We are seeing that as gold prices move up, silver tends to move up more. It's the same on the way down.
In addition, the miners tend to be a beta trade on the underlying metal. Typically, the miners will move even more drastically than the metal price. Then, within the mining space, the junior names tend to have a higher beta play than the more senior producers.
Although the gold-silver ratio had been at near-term highs, I believe we are starting to see that spread collapse a little bit and silver will continue to gain serious ground.
TGR: Why did you choose to build an ETF around junior silver companies instead of large-cap silver miners or midtier producers?
AC: First off, ETFs are like that line in the movie "Talladega Nights": "If you're not first, you're last."
We did not want to be second to market with any of our fund ideas; every element in our suite of products is the first of its kind. When we looked at the precious metals mining space, we saw several gold equity plays. We wanted to create the first junior silver mining fund.
People who are fans of the junior mining space are there because they get that higher beta play. If investors believe silver prices are on the rise, we thought the best vehicle would be giving them access to a basket of junior silver stocks. But the movement, the volatility and the risk-reward profiles weren't the only reasons that we were interested in the junior space.
People who invest in mining companies have a higher risk-reward profile than others. They, and the companies they invest in, run different types of risk. There is company risk where management might not perform or a crisis hits the company, reducing its market cap. There also is nationalization risk, where a country takes over a producing mine.
We wanted to provide a way for investors to get a basket of these companies to diversify or mitigate some of that risk. You can't eliminate company risk, but you can try to protect against the amount of risk any one company contributes to the risk profile of your entire investment by diversifying. By trading a basket of junior mining companies, you don't need to pick that one superstar company; instead, you have a group of companies that should track the industry as a whole.
TGR: Tell us about the index that your junior silver ETF tracks.
AC: The index was created by the International Securities Exchange (ISE) and contains between 20 and 40 junior silver companies. When the index was created, the ISE looked at certain volumes and dollar values traded on a daily basis by the companies to ensure ample liquidity for the fund. On top of that, ISE wanted to see market caps between $50 million ($50M) and $2 billion ($2B). The $2B ceiling made sense, being that junior companies are typically explorers or if they are in production it's on a low scale. We wanted junior companies so investors would be able to take advantage of the many different aspects that they offer. For example, juniors could be takeover candidates, they could have the next great discovery or they could partner with senior producers to put the mines into production or grow organically.
TGR: You and Paul helped determine the companies in this index, correct?
AC: We wanted to because it's an area that we track very closely, but due to compliance rules, there had to be a separation, so we did not pick the stocks.
TGR: Which silver companies carry the heaviest weighting in the ISE Junior Silver ETF?
AC: Currently, the top four are Silvercorp Metals Inc. (SVM:TSX; SVM:NYSE), Fortuna Silver Mines Inc. (FSM:NYSE; FVI:TSX; FVI:BVL; F4S:FSE), Endeavour Silver Corp. (EDR:TSX; EXK:NYSE; EJD:FSE) andMAG Silver Corp. (MAG:TSX; MVG:NYSE). They are the larger companies, the larger weightings, but they also are closer to becoming midtier producers, as well.
TGR: Which have been the best performers since inception?
AC: Since inception, these eight names have tracked the general junior silver space, which means they have been adversely affected by declining silver prices. Unfortunately, none of them has had great performance since inception.
TGR: How about over the last month?
AC: Since the turnaround that started at the end of June, many of these names have come off their near-term lows. We have seen some great increases in price, some upward of 50%, which may be because they had been so severely oversold to the downside.
Also, many of these companies have been using this downturn as an opportunity to examine their cost structures and expenses and to reallocate capital or to look for new properties or low-cost projects.
Just as some of the great contrarian or deep-value investors of our times say, the best opportunity to buy is when everyone hates the space. Over the past couple of months, the precious metals mining space was one of the most hated areas for investing. That meant some names not only saw quick increases to their investment value, they also have been able to look around and make acquisitions while others were selling off assets at fire sale prices.
TGR: In comparison to other ETFs, the ISE Junior Silver ETF has done well.
AC: Yes. In July 2013, for all U.S.-listed ETFs, excluding leveraged ETFs and inverse ETFs, the ISE Junior Silver ETF was the second-best performing ETF. More people have been picking up on it due to that performance, and those gains didn't just sell off at the end of the month. There has been follow-through.
TGR: Which companies do you believe have catalysts that will help the ETF continue its run?
AC: Some of these catalysts apply to all the companies because their prices have been so abused. Across the board, these companies have been oversold, so many will benefit from an increased price in silver going forward.
Excellon Resources Inc. (EXN:TSX) is an example. Its operating cost to extract an ounce of silver is in the low $20s/ounce ($20/oz), which puts it among the lower-cost producers, especially in the junior space. If the silver price increases, it could bounce back very quickly. Excellon is looking for potential properties for acquisition at low valuations.
TGR: Could that result in a merger of two companies in the index?
AC: I'm not apprised of the targets Excellon is looking at, but that could happen.
It is interesting that many companies in the silver space will sit on cash, especially when the spot price of the metal has gone down. Some miners sit on their inventory of produced silver instead of selling it into the markets. Excellon is doing it a different way by investing in the Sprott Physical Silver ETF (PSLV) to get that kind of price movement to silver. This gives Excellon some investment correlation based on the performance of silver associated to its cash position.
TGR: One of the main reasons Excellon is such a low-cost producer is that it has the highest-grade silver mine, the La Platosa mine in Mexico. Are there other companies where grade is such a significant factor?
AC: Aurcana has some interesting high-grade deposits. Mexico has some very impressive ore grades. Through our underlying index, the fund holds some companies that are sitting on impressive-looking reserves.
TGR: There are not many pure silver plays in the junior mining space. How important to the performance of your fund are the other commodities these companies are producing?
AC: Primary silver companies are very rare because there aren't many primary silver deposits. Typically, zinc, copper, gold and lead tend to be byproducts of silver mining. Some of the companies in the ISE Junior Silver ETF have offtake agreements, and the sale of these other commodities can help their cash situation.
The index is constructed to remove or decrease the weighting of companies as their operations become less silver-reliant and to increase the weighting for companies that acquire more silver-heavy assets or begin to produce higher quantities and percentages of silver.
The companies in the ISE Junior Silver ETF aren't completely insulated from the costs of some of those byproducts, however the index attempts to give higher weighting to those companies that are more focused on silver.
TGR: Tell us about a couple of the companies in the index that are producing silver along with significant quantities of other commodities.
AC: Trevali Mining Corp. (TV:TSX; TREVF:OTCQX) has some heavy zinc deposits in production and in reserve. They could buoy the stock in times when zinc does well.
Perilya Ltd. (PEM:ASX) in Australia is mining a wide range of metals. In addition to silver, it has exposure to copper, gold, lead and zinc.
TGR: Trevali recently started producing zinc and lead-silver concentrate at its Santander mine in Peru. Do you expect that to translate to the share price?
AC: I certainly do. It would be impossible for the production of those metals not to have an effect on the share price because they are such impressive quantities, zinc particularly.
TGR: You talked about grade earlier. What other miners have high-grades?
AC: Silver Bull Resources Inc. (SVB:TSX; SVBL:NYSE.MKT) was added to the index in June and we are very excited about it. Its Sierra Mojada project in northern Mexico is in a very shallow silver zone. Anytime you don't have to move tons of earth to get to the shiny stuff, it's a very good situation. Its property is in historically mining-friendly jurisdictions.
Silver Bull's management has been judicious. Unlike other companies acquiring projects when prices were running up, Silver Bull was not buying whatever it could just because the property contained metal. Management was wise and value-oriented in looking at ore grades when figuring out production costs to find a balance between good jurisdictions and high-grade projects.
TGR: Some of the better names in the junior mining space have seen dramatic share price increases this month. Colossus Minerals Inc. (CSI:TSX; COLUF:OTCQX), Copper Fox Metals Inc. (CUU:TSX.V) and a couple of the names you mentioned have seen increases greater than 50%. Has the "brand-name" section of the junior mining space turned the corner?
AC: I believe that we have seen a turnaround. It was due, in part, to the fact that some of these names had been so badly punished, but even more to the fact that the spot price had dropped so low. Only a handful of companies can produce profitably with silver prices below $20/oz. At that point, you have to cut costs. You have to shut down mines, and when you shut down mines, you remove silver supply. Removing supply affects the whole supply-demand chart.
We were seeing an artificially low price for silver, by which I mean a price lower than what the supply-demand structure would suggest. These artificially low silver prices caused the sharp decline in silver miners, leading to names trading to all-time or multiyear lows; silver's rally back over $20 helped these oversold names come back with such vengeance in recent weeks.
If spot silver prices can recover to where they were at the start of 2013, these names should benefit.
TGR: What other mining-related ETFs are in the PureFunds stable?
AC: We launched the first Diamond/Gemstone ETF (GEMS), a global equity basket. It contains roughly 60% diamond and gemstone explorers and producers; the remaining 40% of the companies are on the retail side. Diamonds go through a lot on the way to becoming an end product, so it made sense to have a global, diversified basket of companies mining for diamonds, as well as being positioned to take advantage of the growing demand in India and China, where the idea of giving diamonds as an engagement gift is spreading for the first time. We thought that having a mix of retailers in the fund would deliver the best picture of what diamonds are doing as a commodity.
Our third ETF is the Mining Service ETF (MSSX). It is a basket of global companies that provide services or equipment to mining companies. We are very proud of this fund. Again, it is the first of its kind.
There are five or so oil service/oil equipment ETFs, but guess how many mining service ETFs there were? Zero. We wanted to give the same type of exposure available in the oil industry to companies operating in the mining sector.
These companies have some correlation to the metals that their equipment or their services are geared to, but they don't have the same volatility and correlation as a miner, producer or explorer would have. These companies typically get cash up front, whereas a mine might take 5 to 10 years to produce a revenue stream. They get paid on as-you-go payment plans, so their balance sheets and revenue streams are vastly different from mining companies.
They do, however, benefit when spot prices go up because when that happens, companies tend to use their services more as they explore, examine more drill results and look for new properties to expand their reserves and asset bases.
The other thing that makes mining services and equipment so interesting is that these companies are usually under the radar. There aren't many pure play companies in the U.S, and they also tend to keep their heads down and make money. They haven't had to go out and raise money like the mining companies. They haven't had to hire investment banks to do research reports and talk the story up. As a result, they've been able to maintain interesting cash positions, and many have paid dividends. This is a way to get exposure to the mining industry and get a dividend.
TGR: You recently declared the first quarterly distributions from the Diamond/Gemstone and the Mining Service ETFs. Were they above or below estimates?
AC: They were in line with our estimates.
TGR: Are you planning any more mining ETFs?
AC: Right now, our passion is the funds that we have launched. We would like to get more follow through on them before bringing any more to market.
TGR: Do you have any parting thoughts on silver?
AC: The last time the financial minds met in Washington, D.C., we saw a drastic selloff in metal prices. We expect that again in the short term, but there are so many different fundamentals in play.
In brief, we believe the silver price, especially in relation to gold, will be incredible. We think that exposure to silver is just as important as exposure to gold, not only for protection, but also through the junior miners as leverage to that investment.
TGR: Andrew, thank you for your time and insights.
Andrew Chanin is the co-founder and chief operating officer of PureFunds. Previously he worked in the prop trading unit of Cohen Capital Group specializing as an ETF Arbitrage trader. He began his career on the American Stock Exchange for Kellogg Capital Group. Chanin has made markets in over 100 ETFs, and this experience has provided him with a vast knowledge of all varieties of ETF products. Chanin holds a Bachelor of Science in Management degree in finance from Tulane University.