Hedge Fund Ratio Spread Trades Continue to Distort the Value of the Mining Shares

I hope to have further on this topic sometime this weekend depending on time constraints but I wanted to at least get some charts up to demonstrate how severely undervalued many of the mining shares are in relation to the underlying metal as a result of the plying of this particular trading strategy.

One of the factors that I believe are involved with this severe underperformance of the shares in general is the advent of the ETF's. Those who want LEVERAGED EXPOSURE to either or both gold and silver can now use the ETF's to do so.

Formerly, there were two methods available - commodity futures or mining shares. Since the charters of some funds prevents them from investing or trading in commodity futures, funds who wanted this leveraged exposure to the metals were forced to go into the mining shares in the past. That implied that bull markets in the metals were going to see substantial money flows coming into the shares.

Since the ETF's came along, those institutions looking for leveraged exposure to gold can now directly purchase the silver or gold ETF's instead and margin those up to obtain leverage. In other words, they are no longer captive to using only the mining shares.

Additionally, the hedge funds, which have proliferated like mushrooms after a summer rain, are able to offer prospective clients exposure to the commodity markets since there is nothing in their charters preventing them from investing in the commodity markets. That attracts further funds that in time past would have flowed into the mining sector directly.

Keep in mind what is necessary to drive prices higher - sustained investment flows. Now, if the investment flows that formerly would be diverted directly to the mining shares have been split and are now moving directly into the commodity futures markets and the ETF's, that pulls a portion away from the shares. That means that there is a bit of an exploitable weakness, a chink in the armor if you will,  in the sense that the amount of firepower coming into the shares, is weaker when compared to the other alternative forums for investing in the precious metals.

The hedge funds understanding this then employ a strategy designed to take advantage of the "weaker sister" which suffers somewhat from the smaller money flows heading its direction - they short some of the mining shares while buying the commodity futures and the ETF's. That selling then further absorbs the buying interest that is still heading into the mining sector shares.

The reason they do this is because it helps them manage their risk. When the market sells off in this volatile environment, they are able to profit from the short leg of this trade as the shares head lower generally at a faster rate than the metals themselves do. In other words, they might be losing $1.00 on their long gold or silver positions in the futures or ETF's, but making $1.10 - $1.20 on their short share position. In effect, they have a permanent put option.

This trade has been extremely effective for them which is why they seemingly refuse to give it up but at some point, the effect is to so distort the price of the mining shares in relation to the underlying metal, that something has to snap to bring the share price back in line to historical norms. After all, the higher the metals run in price, the more profitable the well run miners become. Stock prices are eventually determined by profits - Eventually some of the hedge funds plying this trade will begin to realize that they are pushing the trade too far and will begin to exit. That will set off a rush by the others to do the same.

We got a brief taste of this April 5 of this year when the HUI shot up nearly 30 points in a single day. That was the first sign that the days of this trade are drawing to a close. There is an old adage in the trading world which is apropos for this situation:

Bulls make money; Bears make money; but Pigs get slaughtered.

Hedgies beware. The time is coming when there are not going to be any sellers on the other side of your trade when you need to unwind it.