Silver LOF: Each generation has its own tiered system (B)

Authors: Shen Hui & Zhang Jieyu, Yuanchuan Investment Review

Before January 30, the Guotou UBS Silver LOF had risen by 263.13% in one year, ranking first among all public funds in the market.

As the only domestic fund authorized to invest in silver futures, despite issuing 20 premium risk warnings since the beginning of the year, it has been unable to curb the market's animalistic tendencies and frenzied bullish enthusiasm. Silver LOFs have been repeatedly pushed to their daily limit, even reaching a 61.6% premium in the market.

Internet "coupon hunters" followed suit, giving rise to the most frenzied "group buying" frenzy in the history of public funds.

If you feel that going to work every day is like going to a funeral, all you need to do is use your spare time to subscribe to 100 yuan worth of silver LOF (Listed Open-Ended Fund) in your securities account, and sell it two days later like stocks. A profit of over 50 yuan from the exchange premium will fall from the sky, making those tiny bonuses from online money market funds pale in comparison. If you mobilize all six wallets of your family to participate, find a brokerage firm offering a 90% discount or even a 50% reduction in subscription fees, and through a series of cost-saving measures, you might even be able to afford a New Year's Eve dinner at Xinrongji Restaurant.

This is why, when the market was booming, 400,000 people joined this arbitrage opportunity every day.

But all of this is based on an important but forgotten premise—that silver prices do not fluctuate drastically.

As expected, an unexpected event was bound to happen, and the euphoria was quickly interrupted by the collapse of silver prices.

Last Friday, spot silver prices plummeted 26%, marking the largest single-day drop in history. On Monday, silver LOFs resumed trading and hit their daily limit down. After the market closed, based on international futures prices, Guotou UBS's off-exchange net asset value opened at -31.5%. Whether you chased the price limit up or tried to profit from the price surge, everyone was silent that night.

This move caused the actual premium rate in the market to soar to over 100%, and the company will face at least several limit-down days in the future. If they did not withdraw in time before the trading halt last week, it would be like having the car door welded shut and being locked up and beaten up.

Thematic funds are experiencing a bull market, with soaring premiums and a flood of arbitrage posts, followed by violent downward adjustments to net asset value—history seems to be entering a cycle. Similar scenes are reminiscent of the 2015 bull market, which was equally hot but ultimately left behind a mess of leveraged ETFs (B shares).

"Downward Discount Crisis"

In response to the gap between international silver prices and the daily price limits for Shanghai silver futures, Guotou UBS announced last night that its silver LOF (Listed Open-Ended Fund) would experience a -31.5% drop, setting a new record for the largest single-day drop in the history of public funds.

However, the way this record came about is highly controversial.

On the evening of February 2nd, Guotai Junan Securities announced that the old valuation method could not objectively reflect fair value and that valuation should be based on international asset prices, ultimately resulting in a 31.5% drop. If the valuation method had not been changed, based on the valuation of Shanghai silver futures, the net asset value would have fallen by a maximum of 17%. This new method directly resulted in an additional 14.5% loss, effectively trapping those who bought A-shares for arbitrage or those who bought C-shares to go long on silver.

This almost arbitrary valuation adjustment naturally sparked dissatisfaction among investors:

First, the announcement late at night caught those who redeemed their shares during yesterday's trading session completely off guard, and the resulting psychological blow was akin to accidentally buying into leveraged ETFs during the last bull market and then immediately encountering a downward adjustment. Facing the increased losses felt like having one's body completely drained.

Secondly, when the net asset value rises, it follows the Shanghai Silver Index; when it falls, it incurs losses but still has to act as a global citizen. Temporarily changing the valuation rules is unfair. This is like Barcelona being offside by Mbappe in the Champions League final, and UEFA announcing that the offside rule is abolished and all the goals are valid.

In response, Guotai Junan Securities stated that if an announcement were made in advance, it might be interpreted as an attempt to discourage investors from redeeming their funds, leading to speculation that the fund's assets were experiencing serious liquidity problems, triggering market panic and a run on the fund.

If the original valuation method is used, the 30% or more drop would be written off in one go and then spread over several days. If so, savvy investors could quickly sell their shares and cause a run on the market. In that case, Guotou UBS might not be able to sell its futures contracts, and the resulting liquidity risk is quite severe. From the perspective of quickly and steadily eliminating its own operational risks, this seems to be a good solution.

However, this is a huge blow to those who are eager to profit from the "in-exchange premium" arbitrage. When they submit their redemption orders, the rules are still the same. They expect to be able to profit from the Shanghai-Hong Kong Stock Connect trading mechanism again. Who knew that the final whistle would blow and the fund company would come out and say that the rules would be changed, and none of them could escape.

C-share investors who rushed into the market because silver was still rising were only buying a Shanghai silver futures fund, but were experiencing the brutality of the international futures market; while A-share buyers who happily learned how to switch from off-exchange to on-exchange trading because of the huge arbitrage opportunities found that they were still a long way from their dream of "risk-free arbitrage".

This lesson was clearly taught to people back in 2015. After the bull market peaked in June, most stocks experienced consecutive limit-down days. At that time, the most innovative product in public funds—the leveraged ETF (B shares)—began to offer opportunities for "arbitrage"—the net asset value of some leveraged ETFs (B shares) fell by 20%-30% per day, while the trading price of leveraged funds could only fall by 10% per day.

This has led to two problems: the premium rate of the low-net-value B shares has risen rapidly, generally exceeding 100%[1]; on the other hand, the premium rate is "priced but not traded", investors holding B shares are trapped at the limit down price and cannot exit at a fair price. They are passively waiting for the B shares to be downgraded, which further expands their losses.

In the last bull market, many people only knew that leveraged ETFs (Class B shares) had leverage when the market was rising, but they didn't know that when the market fell too far, Class B shares also had a downward rebalancing mechanism. After falling below 0.25, the fund will ignore the high market price you bought at (such as 0.5 yuan) and force you to rebalance based on the true low net asset value, causing the high premium bubble you paid to instantly disappear and your assets to face huge losses of up to halving.

However, some investors still rushed to buy on the lower rebalancing date, like moths to a flame. But when the market crashed, most people didn't have the ability to catch the falling knife; they only suffered heavy losses. The wave of lower rebalancing of leveraged ETFs (B shares) was beyond the control of those trying to buy at the bottom, making it the most devastating battleground for mutual funds during the 2015 stock market crash.

Ultimately, this led to the complete exit of this tiered fund, which had once touted itself as innovative, from the industry stage, leaving it stigmatized and disgraced.

It's important to know that silver LOFs themselves don't have a downward adjustment mechanism, but the free fluctuation of international silver prices and the bug in the price limit restrictions of Shanghai silver ultimately led to a new generation of holders experiencing the "leverage" of leveraged ETFs, even after the valuation rules were revised overnight.

Did this bug exist beforehand? Yes. But were people aware of it? Perhaps even SDIC UBS hadn't prepared a contingency plan, which is why they hastily offered this inevitably criticized solution at 10 PM.

Bull Market Mirror

Looking back at the silver LOF and leveraged B shares during the two bull markets, it always seems like history doesn't repeat itself monotonously, but it always carries a similar rhyme.

Leveraged funds (Class B shares) left a bad impression on veteran stock investors due to their leveraged nature. Leveraged funds split the parent fund into Class A shares (stable return side) and Class B shares (aggressive leverage side). Class B borrows money from Class A; Class A earns interest, while Class B profits from volatility—amplifying returns during uptrends and incurring losses several times over during downtrends. If a downward trigger mechanism is activated, losses will be further amplified.

Although silver LOFs do not have built-in leverage, the high volatility of precious metals and the "regulatory risk" of the underlying assets are still a huge blind spot for many buyers.

From an emotional perspective, losing money in a bull market is certainly painful, but seeing friends make money is even more heartbreaking. Extreme FOMO (Fear of Missing Out) necessitates tools with extreme volatility to gain an edge. Whether it's silver LOFs now or leveraged ETFs (B shares) from back then, they've all seen significant premiums driven up by demand.

The high premiums attracted a massive arbitrage army, like locusts swarming across the country.

In June 2015, the size of leveraged funds surged to 500 billion yuan, with 41 leveraged funds doubling their net asset value in six months. Private equity mogul Wang Penghui's ChiNext B fund more than doubled in value. Because subscriptions and redemptions were continuously closed, ICBC 100B saw eight consecutive daily price limits, with a premium rate as high as 78.29%. The Belt and Road B fund saw its size increase 11 times in a week, with nearly 4 billion yuan realizing arbitrage.

When the "Red Book" on leveraged funds, "Leveraged Funds and Investment Strategies," was published, Gao Zijian, the chief financial analyst at CSPC Securities, wrote a passionate recommendation, stating that leveraged funds are a product unique in China's capital market globally.

Just as many people learned about silver LOF arbitrage from Xiaohongshu (Little Red Book), back then, WeChat official accounts and Jisilu (a Chinese investment platform) were full of arbitrage posts. Juquan (a financial information platform) also explained leveraged fund arbitrage—under the bullish sentiment, B shares would see a premium due to frenzied buying, while A shares would see a discount due to lack of demand. If the sum of the prices of A and B shares still showed a premium compared to twice the net asset value of the parent fund, it would be like inviting arbitrageurs into the market, who would then pocket the entire premium.

Interestingly, holders of leveraged ETFs (Class B shares) have emerged using quantitative arbitrage products from companies like Fushen, Minghong, Tianyan, and Shenyi. Back in 2013, Qiu Huiming joined Fushen and spearheaded the development of the Zhiyuan CTA product line, which included leveraged fund arbitrage and cross-market commodity arbitrage strategies. He left just one year later to found Minghong, after which Fushen gradually faded from the forefront, while Minghong gradually became a leader in the industry.

This round of silver LOF arbitrage is driven by the general public, excluding institutional investors.

Starting last October, the price of silver LOF A shares experienced a volatile cycle, fluctuating between 6,000 yuan, 100 yuan, 500 yuan, and back to 100 yuan, until subscriptions were suspended on January 28th. While silver prices surged dramatically, arbitrage opportunities were extremely limited, causing the premium for silver LOFs to quickly soar by over 30%. Guided by comprehensive tutorials on Xiaohongshu (a Chinese social media platform), retail investors flocked to arbitrage opportunities, resulting in a 4 billion yuan increase in silver LOF shares in the fourth quarter alone.

Faced with persistently high premiums, Guotai Junan Securities is unable to lift purchase restrictions and can only helplessly issue daily warnings about premium risks. This is because mutual funds face dual restrictions on speculative positions in silver futures contracts for typical months: firstly, a single mutual fund's holdings in a single silver futures contract cannot consistently exceed 10%; secondly, the overall speculative position cap is 18,000 lots.

When the fund size reaches the ceiling of the silver futures position limit, subscriptions must be suspended. There is a serious mismatch between speculative demand and selling supply. Only a sharp drop in silver prices can end the premium situation.

Experience has shown that no matter how many risk warning announcements a fund company issues, if it only vaguely states that "the trading price of this fund in the secondary market is subject to the risk of fluctuations in the net asset value per share, as well as other factors such as market supply and demand, systemic risk, and liquidity risk, which may cause investors to suffer losses," it will only be ignored by ordinary novices who lack the imagination of losses.

When fund companies use general terms like "net asset value fluctuation risk, market supply and demand, systemic risk, and liquidity risk" to describe risks, did they ever imagine that these risks would one day come in the way they do today?

If the institutions themselves didn't anticipate this, how could countless inexperienced investors possibly have? If the institutions were able to anticipate it, why didn't they clearly state the "risks" in their repeated risk warnings?

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When the bullish sentiment among the people reaches its peak, will purchase restrictions really be effective?

In 2016, despite increasingly stringent restrictions on real estate purchases, people resorted to fake divorces, falsified income statements, and social security registrations in other locations just to buy more properties. In 2021, blockbuster products from star fund managers in the public fund industry were subject to purchase restrictions or allocated proportionally, but this did not dampen the enthusiasm of the public who borrowed money to subscribe, fearing that there would not be enough allocations.

The essence of a fast bull market is excess liquidity.

When emotions are still running high, the words "purchase restriction" will be automatically translated as "scarcity"; but when the crash begins, no matter how many risk warnings and announcements are made, they will all become worthless pieces of paper in the face of surging public opinion.

Every generation has its own leveraged funds (B shares), and the next time it won't be silver LOFs. What everyone can learn is that when they see the frenzy of "purchase restrictions not being able to stop the buying enthusiasm" in the future, they should first weigh their own weight, check their investment records, and then try to restrain themselves and use their energy to control themselves and simply not browse social media.

The actual college entrance examination questions are different every year, but that doesn't mean that repeatedly studying "five years of college entrance examinations and three years of mock exams" is useless.