Gold bugs, rejoice!
This year's best-performing ETF of any size is a triple-levered gold miners product that goes by the ticker symbol "NUGT." This ETF, produced by Direxion, aims to deliver triple the returns of the Arca gold miners index in any given session.
Since gold miners have rallied this year on the back of a rebound in the precious metal, it's no surprise that NUGT has done exceptionally well. The ETF is up some 120 percent this year.
For those who believe that the gains in gold are likely to continue, buying NUGT could continue to be a compelling play.
"I think there's a lot of reasons to think that gold can move higher" during March, due to uncertainty around central bank actions, Kathy Lien, managing director of FX strategy at BK Asset Management, said in a Tuesday "Trading Nation" segment.
"A lot of investors might want to look for different ways to play these gold miners," Lien said. And when it comes to NUGT, its high degree of leverage means that "it just takes a small move in gold to lead to larger moves in this instrument," which means it "might not be a terrible way to play" gold now.
Those who are considering buying NUGT now need to be aware of several risks, however.
First, and most obviously, leveraged ETFs are extremely volatile. Those who use the product would naturally consider this to be a feature, rather than a bug. But it's important to take note of just what high volatility means.
Over the last five years, NUGT has risen or fallen 10 percent or more in 7.5 percent of sessions. The same can be said, incidentally, for the inverse product, which provides three times the inverse return of the same gold miners index — and trades under the provocative ticker symbol "DUST."
One problem with high volatility, however, is that over a series of chained periods, it tends to pull an instrument downward. Let's say you own a stock trading at $100; on Monday, it rises 10 percent, on Tuesday it falls 10 percent, on Wednesday it rises 10 percent, and on Thursday it falls 10 percent. What does your profit-and-loss statement look like come Friday morning?
While your brain might initially conclude that you haven't gained or lost anything, that's not actually the case. On Monday, this stock rose to $110, on Tuesday it fell to $99, on Wednesday it rose to $108.90, and on Thursday it fell to $98.01 — for a total loss of 2 percent. The same thing happens if the sequence goes loss, gain, loss, gain. And if the magnitude of the daily moves increases to 20 percent, the same chain of events loses you about 8 percent.
This is part of the reason why over the past three years, both ETFs are down substantially — NUGT has fallen 72 percent, and DUST is down 47 percent.
The performance is also hurt by relatively high fees — each ETF charges about 1 percent in annual expenses.
Of course, for products that move more than 1 percent in 86 percent of their sessions, annual expenses are pretty unlikely to be the predominant determinant of returns. And to Derexion's credit, its website warns potential NUGT or DUST investors in bold font: "The funds should not be expected to provide three times or negative three times the return of the benchmark's cumulative return for periods greater than a day."
Indeed, "investors" is probably the wrong word to describe users of the product. Due to the high fees, and their ugly returns over long time periods, these products probably ought to be considered derivatives rather than securities. To that point, the ETFs use a popular institutional derivatives product — swaps — to generate their leverage, essentially making NUGT and DUST derivatives on derivatives.
That's not to say the products don't have benefits. If an investor can correctly predict that gold miners will rise in a given session, buying NUGT will be far less capital intensive than buying the vanilla gold miners ETF, GDX. This efficiency allows investors to do other things with the remaining funds — and may have additional appeal for those who care to separate their tactical "bets" from their more standard and stable asset allocation decisions.
"People like to have that peace of mind. They think, 'I'm going to spend a smaller dollar amount, and if I lose that amount, I'm OK with it,'" commented Mohit Bajaj, director of ETF trading solutions at WallachBeth Capital.
Of course, for investors who are religiously bullish on gold, simply buying and holding NUGT may have merit. After all, the volatility effect only removes value if that volatility goes both ways. If gold miners just rise and rise, NUGT will simply go higher and higher.
"In order to be holding something like this, you really have to believe Armageddon" is upon us, Gina Sanchez, founder and chairwoman of Chantico Global, said Wednesday on CNBC's "Trading Nation."
There's even a kink to that argument, though. NUGT (like DUST) primarily bundles together swaps contracts, which are agreements between financial institutions. If the party on the losing side of one of these swap agreements goes bankrupt and defaults, the winner will enjoy only a pyrrhic victory.
If the End Times do arrive and cause widespread failures of financial institutions in addition to a massive spike in gold prices, then, NUGT holders may wish they had stocked up on water and granola bars instead.