JDST - JDST: A Leveraged ETF I Would Avoid
2024-01-19 10:27:50 ET
Summary
- The Direxion Daily Junior Gold Miners Index Bear 2X Shares ETF provides -2x exposure to junior gold miners.
- Leveraged ETFs like JDST are only designed for short-term trading and can experience significant tracking error over longer periods.
- There are several bullish factors for gold investments, including rising interest rates and emerging market demand, which will act as a headwind for JDST.
Recently, I wrote a cautious article on junior gold miners, as represented by the VanEck Junior Gold Miners ETF ( GDXJ ). Since I believe junior gold miners will underperform in the long-run, is it fair to reason that the Direxion Daily Junior Gold Miners Index Bear 2X Shares ETF ( JDST ) should outperform?
The short answer is a no. Although nimble traders can capture significant swing gains with levered ETFs like JDST, in the long-run, the JDST is a decaying product that will lose value. Furthermore, I believe gold is setting up for a breakout in 2024, so I would be hesitant to bet against gold investments. I would personally avoid the JDST ETF.
Fund Overview
The Direxion Daily Junior Gold Miners Index Bear 2X Shares ETF seeks daily returns that are twice the inverse returns of the MVIS Global Junior Gold Miners Index ("GDXJ Index"), the underlying index of the GDXJ ETF.
The JDST ETF achieves its levered returns by holding cash plus total returns swaps with leading investment banks like Goldman Sachs that are reset nightly (Figure 1).
Investors interested in the JDST ETF are highly encouraged to review warnings regarding levered ETFs that FINRA and the SEC have compiled.
Levered ETFs Only Designed To Work In The Short-Term
To understand the mechanics of the JDST ETF, investors need to understand that levered ETFs only provide their intended exposure on short-term time frames. When investors start to view levered ETFs beyond the 1-day horizon, volatility and convexity will start to introduce tracking error.
For example, if we started off with $100 invested in JDST, if the index returns -5% on day 1, the position will grow to $110 (2 times 5% return). If the index returns -5% again on day 2, the position will grow to $121.00, more than twice the theoretical 2-day compounded return of 10.25% or $120.50. Conversely, consecutive 5% gains on the index will lead to an ending value of $81.00 for JDST, better than a theoretical ending value of $80.50.
This tracking error is caused by 'positive convexity' . Levered ETFs have positive convexity in the direction of their bets. In the case of JDST, if the GDXJ Index declines every day, then investors' exposure will increase exponentially.
On the other hand, if the underlying index returns are -5% followed by +5%, investors end up with $99.00, significantly less than the twice the 2-day compounded loss of 0.25% or $99.50. This 'decay' is from volatility.
It is important to remember levered ETFs have 'positive convexity' in the direction of its bet (i.e. the exposure grows as the bet is winning), and it loses value from 'volatility decay' .
Inverse ETFs Are Not Designed For Long Holdings
While the day-to-day tracking error may appear small, when we compound the tracking error over weeks and months, it can lead to very significant deviations in expected returns.
For example, even though the GDXJ ETF lost 10.7% in the past year, the JDST ETF actually lost 4.8% as well (Figure 2). This means returns for the JDST ETF were not even in the right ballpark as expecations!
Figure 2 - JDST and GDXJ both lost month in 2023 (Seeking Alpha)
In fact, the long-term performance of the JDST ETF has been abysmally poor, with a 3-year annual return of -34% (Figure 3).
Figure 3 - JDST historical returns have been poor (direxion.com)
Readers should note that performance prior to April 2020 are not representative of the JDST ETF's current strategy, as many levered ETFs were forced to reduce their leverage from 3x to 2x due to the extreme volatility caused by the COVID pandemic.
Volatile Products Like JDST Are Designed To Underperform
The key driver behind JDST's poor performance is the volatility of the underlying index. According to Direxion's modeling, a -2x product like JDST only outperforms its underlying index over a year if volatility is low (i.e. the index consistently moves in 1 direction only) (Figure 4).
Figure 4 - Theoretical returns of -2x products (JDST prospectus)
However, junior gold miners are a volatile asset class, with historical 30-Day implied volatility between 30-60% (Figure 5). So almost by design, the JDST ETF will underperform its expected outcome.
Bullish Long-Term Outlook For Gold
Furthermore, I believe there are fundamental reasons to be bullish gold and gold investments in the long-run, as I have detailed in a recent article on the SPDR Gold Shares ETF ( GLD ).
First, gold and interest rates are intimately intertwined, as gold is a non-productive asset whose utility is primarily as a store of value . When interest rates rise, there is a higher funding cost to holding gold, as gold neither pays dividends nor interest. Thus it becomes relatively unattractive to hold gold in a portfolio when real interest rates are high.
On the other hand, when real yields are negative, holders of cash and bonds are actually losing wealth, since inflation is higher than interest earned. So when interest rates are declining, gold becomes relatively more attractive. With the Federal Reserve expected to cut interest rates in 2024, that should act as a tailwind for gold and gold investments (Figure 6).
Figure 6 - Fed is expected to cut interest rates in 2024 (CME)
The second reason why I have a bullish outlook for gold is because emerging market central banks like Russia and China are trying to setup an alternative to the U.S. dollar, backed by gold.
Ever since Russia's invasion of Ukraine and the subsequent weaponization of the U.S. dollar against Russia, many emerging countries like China have seen firsthand that the safety and availability of their U.S. dollar assets are dependent on America's goodwill and can be taken away overnight. For these countries, the solution to this problem is to setup a financial system outside of the U.S. government's control that is backed by hard assets like gold.
We can observe this emerging market demand for gold indirectly via the premium of gold prices in China compared to other parts of the world. When the Chinese gold premium is high, it means it is more attractive for producers to ship their gold to China (Figure 7).
Figure 7 - Chinese gold premium surged to all-time highs in 2023 (Bloomberg)
Finally, there is also a growing international backlash against out of control fiscal spending by the U.S. government. In 2023, both Fitch and Moody's have downgraded their credit rating on the U.S. government in response to the political dysfunction in Washington that makes fixing the budget unlikely.
According to the Congressional Budget Office ("CBO"), even adjusted for the Fiscal Responsibility Act of 2023 ("FRA"), the U.S. government is expected to run large and expanding deficits for the foreseeable future, from $1.5 trillion in 2023 to $2.7 trillion in 2033 (Figure 8).
Figure 8 - CBO forecast large and expanding deficits (CBO)
For foreign governments like China, the calculus is very simple. Rather than hold U.S. dollar assets that could potentially be frozen in a geopolitical spat or become worth a lot less due to fiscal profligacy, it may be much safer to convert foreign reserves into gold that has been a store of value for centuries.
With these short/medium/long-term tailwinds for gold, I believe the long-term picture for the JDST ETF is bleak, in addition to its long-term volatility decay.
Risks To Being Overly Cautious
While I am cautious on the JDST ETF overall, that does not mean nimble traders cannot make money with the fund. If one can correctly time corrections in the underlying GDXJ Index, then the JDST ETF may be a viable swing trading tool. For example, just within 2023, the JDST ETF had three trough-to-peak 60% return swings (Figure 9).
Figure 9 - JDST may be useful for nimble traders (Author created using stockcharts.com)
However, gains with the JDST ETF must be monetized quickly, as the long-term price trend of the fund is down.
Conclusion
The Direxion Daily Junior Gold Miners Index Bear 2X Shares provide -200% exposure to junior gold miners. As a levered fund, the JDST ETF is expected to decay over time due to volatility, making it a poor investment in the long-run. Furthermore, there are several catalysts arguing for a bullish long-term outlook for gold, which will be a headwind for JDST.
Investors lucky or skilled enough to catch a short-term rally in JDST should monetize their winnings, as long-term gains are virtually non-existent. I would personally avoid the JDST ETF.
For further details see:
JDST: A Leveraged ETF I Would Avoid