E DUST: Gold Is Sensitive To Disappointment From The Fed

An increasingly dovish Fed has raised the probabilities of rate cuts ahead, which has weakened US Dollar. There is perceived to be a negative correlation between the USD and gold prices, as a weaker dollar makes dollar-denominated assets (such as gold) cheaper to buy internationally. Consequently, the weakening USD has allowed gold prices to rally lately. Higher gold prices, in turn, favor gold miners whose revenues are highly dependent on the precious metal’s price. Hence expectations of looser monetary policy conditions ahead has allowed the stock prices of gold miners to rally, which is unfavorable for the Direxion Daily Gold Miners Index Bear 3X Shares ETF (DUST), as it shorts gold miners (x3). The ETF is down -51.13% YTD. Nevertheless, the market’s expectations of the extent to which the Fed will ease monetary policy this year may have gone too far, and thus prices of asset classes such as gold may have become increasingly sensitive to disappointment from the Fed in the form of less dovish actions/ communication, which could result in short-term upward movements in the DUST ETF. Though the negative correlation between the US Dollar and gold may not be strong enough to support the case for shorting gold miners.

Prospectus Review

Before we assess the impact of the Fed on the DUST ETF, we must first evaluate the fund. The ETF aims to offer triple the inverse return on the NYSE Arca Gold Miners Index, in other words, it shorts (x3) its aforementioned underlying index. In order to deliver leverage (x3), the fund’s strategy incorporates the use of derivative products such as Swaps and Futures contracts. The use of such derivatives magnifies the fund’s risks as they incur greater volatility and liquidity risks. Below one can find the historical discrepancies between changes in the fund’s NAV and market price.

Source: iShares

It is interesting to note that the discrepancies in performance are actually in the investor’s favor.

Furthermore, it is extremely essential for anyone seeking to gain exposure to Gold miners through this leveraged ETF to understand the effects of compounding. Note that the fund’s objective is to deliver inverse (x3) the fund’s objective on a daily basis (no longer than a trading day). Over time, the daily returns will be compounded on top of the closing price of each previous trading day, resulting in the fund’s returns deviating away from the inverse (x3) objective over longer periods of time. However, this compounding actually works in the investor’s favor, in both directions. Having calculated the math behind it, the leverage ratio is greater than x3 when the underlying index is moving in a favorable direction for the investor. Conversely, the ratio is less than x3 when the underlying benchmark index is moving against the investor. Furthermore, the exact ratios in both directions depend on the holding period, whereby the longer the holding periods, the more favorable the ratio in both directions (i.e. greater during upside, lower during downside). Therefore, if investors are able to accurately gauge when the DUST ETF will witness a bullish uptrend due to favorable movements in the underlying index, they could end up generating a return even greater than the fund’s objective of ‘x3’. Conversely, if the investment does not work out in the investor’s favor, they will lose less than the fund’s stated objective of ‘x3’. Hence, the fund’s leverage compounding effect offers more upside potential than downside risk.

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