DUST - DUST: Don't Watch Your Investment Turn To Dust

2023-03-23 19:59:13 ET

Summary

• DUST provides -2x exposure to the NYSE Arca Gold Miners Index.
• Levered ETFs suffer from volatility decay. The more volatile the asset class, the greater the decay.
• Gold is setting up bullishly as the Fed is likely done hiking interest rates this cycle due to banking system concerns despite high inflation.
• Strong gold and gold miners price action will be very negative for the DUST ETF.

The Direxion Daily Gold Miners Index Bear 2x Shares ETF ( DUST ) gives -2x exposure to the NYSE Arca Gold Miners Index. Levered ETFs inherently suffer from volatility decay, which almost guarantee they lose money. In addition, if the Fed is done with interest rate hikes this cycle with inflation still stubbornly high, that could set up the next move higher for gold and gold miners. This could be very negative for the DUST ETF.

Fund Overview

The Direxion Daily Gold Miners Index Bear ETF seeks daily returns that is -2x the return of the NYSE Arca Gold Miners Index ("Index"). The fund achieves its -2x daily return target by entering into total return swaps with large banks that are reset nightly (Figure 1).

The DUST ETF has $94 million in assets and charges a 0.92% net expense ratio.

In February, the DUST ETF reported a $0.15711/share distribution for shareholders as of March 21, 2023, to be payable on March 28th. However, investors should not expect regular distributions from this ETF, as it based on total return swaps and does not earn regular income.

Levered Short ETFs Only Work On Short Time-Horizons

Investors who are interested in the DUST are highly encouraged to read this disclaimer from the Direxion website:

Leveraged and inverse ETFs pursue daily leveraged investment objectives which means they are riskier than alternatives which do not use leverage. They seek daily goals and should not be expected to track the underlying index over periods longer than one day. They are not suitable for all investors and should be utilized only by investors who understand leverage risk and who actively manage their investments.

In layman terms, what this means is that DUST is only designed to provide -2x returns for one day. For any extended holding period, the realized returns will differ materially from the expected returns.

For example, imagine we invested $100 into DUST. If the underlying index returned -5% on day 1, our investment in DUST will grow to $110 (2 times 1-day return of 5%). If the index returns -5% again on day 2, our investment will grow to $121. The 2 day total return is more than 2 times the 2-day compounded return of 10.25% or $120.50. This is due to the 'positive convexity' of levered ETFs that magnify returns in the direction of its bet.

On the other hand, if on day 2, the index returned +5%, then our investment in DUST will fall to $99, instead of $99.50 that can be expected from twice the 2-day compounded return of -0.25%. This is due to 'volatility decay' of levered ETFs.

Watching Investments Turn To Dust

Volatility decay coupled with the long-term upward trend of stocks (yes, even gold stocks tend to trend up) means that an inverse ETF like DUST is almost guaranteed to lose money. In fact, over the trailing 2 years, even though the NYSE Arca Gold Miners Index has declined 7.1%, the DUST ETF has actually lost 46.1% in value (Figure 2).

DUST's performance is even worse if we stretch the returns history further, but investors should note that the DUST ETF changed its leverage from -3x to -2x due to extreme volatility during the COVID pandemic, so historical returns are not comparable.

Is The Fed Done Hiking Interest Rates?

On March 22nd, 2023, the Federal Reserve had its second FOMC meeting of 2023 and raised the Fed Funds rate by 25 bps, bring the total amount of tightening to 475 bps within 1 year.

As I wrote in a recent article on the Sprott Physical Gold Trust ( PHYS ), the Fed is caught between a rock (stubbornly high inflation rates) and a hard place (a looming banking crisis). Many pundits were expecting the Fed to hold off on raising interesting rates, in fear of further worsening the developing banking crisis.

Although the Fed chose to increase interest rates by 25 bps at the March meeting, future interest rate increases appear uncertain and will be driven by incoming data. In particular, Chair Powell noted in his press conference that "events in the banking system over the past two weeks are likely to result in tighter credit conditions for households and businesses" that could be equivalent to a rate hike or more, so the Fed may have "less work to do" on monetary policy.

Furthermore, when asked by a journalist about the change in the wording of the FOMC statement from "ongoing increases in the target range will be appropriate" to "some additional policy firming may be appropriate", Chair Powell emphasized the words "may" and "some" as opposed to "ongoing" . Reading between the lines, Chair Powell appears to me to be conceding that the Fed is done raising interest rates, unless the banking crisis blows over in the coming weeks without negatively impacting the economy and inflation reaccelerates.

A Fed Pause Is Bullish Gold

Looking forward, with core PCE inflation still running hot at 4.7%, if the Federal Reserve is indeed finished raising interest rates for this cycle, then that could give a strong boost to gold prices, and by extension, gold miners.

Despite soaring inflation in 2021 and 2022, investors have so far remained sanguine about long-term inflation, as they trust the Fed will bring inflation back under control. The 10-Yr breakeven rate, a measure of long-term inflation expectations, remain well anchored below 3% (Figure 3).

However, if the Fed gives up in its inflation fight due to banking system concerns, then we could see inflation expectations become unanchored. Historically, gold prices have a -0.82 correlation to 10-Yr real interest rates, measured as the Nominal 10-Yr Treasury Yield subtract the 10-Yr Inflation Breakeven Rate (Figure 4).

If inflation expectations become unanchored, we could see real interest rates plunge, which could spur gold onto its next major move higher. Gold investors seem to agree with my analysis, as they pushed gold bullion prices more than $35 / oz higher following the FOMC meeting (Figure 5).

Conclusion

The Daily Gold Miners Index Bear ETF gives -2x exposure to the NYSE Arca Gold Miners Index. Levered ETFs inherently suffer from volatility decay, which almost guarantee they lose money. In addition, I think macro events are setting up bullishly for gold and gold miners as the Fed is likely done with interest rate hikes while inflation remains stubbornly high. This is very negative for the DUST ETF.

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