Silver ETFs: When Froth Overtakes Economic Reason

The recent correction in silver ETF prices was not driven by a sudden collapse in the silver market. Instead, it was a textbook example of how froth can build up when product mechanics are misunderstood and demand temporarily overwhelms supply.

At one point, silver ETFs in India were trading at a premium of 14–16% over the spot price of silver. For a passive product designed to closely track the underlying asset, such a premium was an immediate red flag. What followed was not a crash in silver itself, but a sharp correction in ETF prices as this excess premium unwound.

What Triggered the Silver ETF Correction

Silver ETFs are passive instruments. Their role is straightforward: reflect the price movement of silver as closely as possible, after accounting for expenses and minor market frictions.

In normal circumstances:

• An ETF may trade at a small premium or discount to its net asset value (NAV).
• The NAV itself closely tracks the spot price of silver.

However, the recent episode departed sharply from this framework.

Strong investor demand for silver ETFs, combined with limited immediate supply of units, created a scarcity effect. This led to silver ETFs trading at 14–16% above the spot price of silver, a level that cannot be justified by fundamentals in a passive product.

At that point, the ETF price was reflecting excess demand rather than the underlying value of silver.

Rewinding to the Morgan Stanley Growth Fund Episode

This episode has a striking parallel in Indian market history.

When Morgan Stanley launched the Morgan Stanley Growth Fund (MSGF) in 1994, it was India’s first major mutual fund offering. At the time, concepts such as NAV, closed-ended funds, and listing discounts were poorly understood by retail investors.

Two critical aspects were missed by most investors:

• Unlike an equity IPO, a mutual fund’s NFO starts with a NAV of ₹10, from which expenses are deducted.
• Closed-ended funds typically trade at a discount to NAV once listed on stock exchanges.

Driven by hype and limited understanding, investors bought MSGF units in the informal market at hefty premiums. When the fund eventually listed, it did so at a discount, leading to widespread disappointment and confusion.

The problem was not the product. It was the misunderstanding of how the product worked.

Why Silver ETFs Mirror the MSGF Story

The silver ETF episode reflects a similar behavioural pattern.

An ETF is designed to mirror the underlying asset. In this case:

• The underlying asset is physical silver.
• The ETF’s NAV tracks the spot price of silver, with small tracking differences.

Structurally:

• An ETF cannot sustain a large premium over the underlying price.
• Any significant deviation eventually corrects through market mechanisms.

In the recent episode, investors treated silver ETFs not as tracking instruments, but as scarce assets. Limited unit availability, combined with strong buying interest, created an artificial premium. This scarcity value had nothing to do with silver’s fundamentals.

Just as in 1994, the issue was not the asset itself, but a lack of understanding of how pricing in a passive product works.

Why Silver ETF Prices Fell Sharply

The sharp fall in silver ETF prices puzzled many investors, especially when compared with the relatively modest movement in silver prices.

Here is what actually happened:

• Spot silver prices fell by around 2–3%.
• Silver ETF NAVs also declined by roughly 2–3%, reflecting the underlying movement.
• Silver ETF market prices fell by 14–18%.

The gap between NAV movement and market price movement explains the entire episode.

The bulk of the correction came from the unwinding of the premium, not from a collapse in silver prices. When buying pressure eased, the ETF price realigned with its NAV, resulting in a much sharper fall than the underlying asset.

This is typical of froth-driven corrections. Premiums build quickly, but they disappear even faster.

What Silver ETF Investors Should Watch Out For

This episode offers important lessons for investors using ETFs and other passive instruments.

Key points to remember:

• Passive products are designed to track, not outperform, the underlying asset.
• Small premiums or discounts to NAV are normal. Large deviations are not.
• Buying an ETF at a high premium means paying for froth, not fundamentals.

Investors should always check:

• The ETF’s market price
• The reported NAV
• The spot price of the underlying commodity

Any major disconnect between these three is a warning sign.

Most importantly, investors should resist momentum-driven behaviour in passive products. If a product meant to track an asset starts behaving like a speculative instrument, caution is warranted.

Key Takeaways

• Silver ETFs recently traded at a 14–16% premium to spot silver, indicating froth.
• The situation was driven by demand-supply imbalance, not fundamentals.
• A similar pattern was seen in the Morgan Stanley Growth Fund episode in 1994.
• Spot silver and ETF NAV fell by only 2–3%, while ETF prices corrected by 14–18%.
• The sharp fall was largely due to premium unwinding.
• Understanding product structure is essential when investing in passive assets.

Disclaimer: This article is for general information and educational purposes only. It does not constitute investment advice, a recommendation, or an offer to buy or sell any securities or mutual fund schemes. Mutual fund and ETF investments are subject to market risks. Please read all scheme-related documents carefully and consider consulting a qualified professional before taking any financial decision.