‘Swiss Army Knives’

It’s not unusual for institutional investors to use ETFs like this, and in other ways that go far beyond simple long-term allocation, said Balchunas, who likens the instruments to a Swiss army knife.

"In this case, the ETF is like a palladium warehouse," he said.

It’s not just companies in need of palladium that are tapping the ETF -- it’s also speculators like hedge funds, according to BofA’s Widmer. One quirk of palladium is that some users like oil companies prefer to lease instead of owning it outright, said Widmer.

In June, the cost to borrow palladium for one week climbed to as much as 25 percent as a result of weak supply, said David Jensen, founder of Jensen Strategic, a firm that offers strategic advisory services for the precious metals mining sector. Usually it hovers around 1 percent or less, he said. That’s created an opportunity for lenders, said BofA’s Widmer.

While there’s no harm in using ETFs like this, when investors rely too much on a fund at the expense of its underlying assets, it can distort the price, said Balchunas. If investors prefer to trade the ETF rather than in the primary market for palladium, a premium will arise in the fund’s price.

Premium Spike

The premium in the ETF Securities LLC fund tracking the metal, symbol PALL, spiked to 2.3 percent above its holdings on Aug. 16, according to data compiled by Bloomberg. That’s above its five-year average, but still not large enough to cause worry, said Balchunas.

Also, there are signs that the practice may be winding down. The amount of palladium held by all ETFs rebounded by around 100,000 ounces in August, according to data compiled by Bloomberg. "If you’ve come down 60 percent in terms of holdings, can there really be that much left?" said Jensen. "The remaining holders may actually be investors."

Indeed, some investors have continued to add cash, drawn in by palladium’s rally and the potential for further gains. The fund run by ETF Securities has gained 36 percent this year, while the Europe-listed Zuercher Kantonalbank Palladium ETF, ticker ZPAL, has surged 29 percent.