UGL - UGL: Gold Endures To Prove Secularity But UGL Is A Pass

2024-01-13 21:27:38 ET

Summary

• The Ultra Gold ETF attempts to track the price of gold with a 2x leverage factor, but the mechanics of daily resetting can lead to value erosion.
• UGL has not sufficiently outperformed normal gold ETFs due to the risks associated with leverage and daily resetting when assessing over longer horizons.
• For shorter holding periods, UGL offers cheaper leverage, but for longer periods, other gold ETFs without leverage are more cost-effective.
• Also, the lack of immediate upside catalysts is another reason why we'd especially avoid the leveraged option.

The ProShares Ultra Gold ETF ( UGL ) ETF is a leveraged ETF from ProShares that attempts to track the price of gold using the Bloomberg Gold Subindex but uses daily resetting with a 2x leverage factor. We think gold continues to have a strong case, and has endured against higher rates, which will be coming down somewhat from peaks. However, UGL being a leveraged ETF and the mechanics of daily resetting leveraged ETFs is rather uninteresting to us and should be approached with caution by everyone as we'll later detail, and the issues can be demonstrated in the performance of UGL versus other gold indices which come without leverage and at lower expense ratios.

Notes on UGL

First a note on leveraged ETFs. Because they reset daily after mimicking changes in the index that day by a 2x factor in the case of UGL, there is the problem of value erosion. While a 1% rebound after a 2% drop isn't so bad for the underlying index, having a 6% drop and a 3% rebound is more of a problem. There is a reason why Warren Buffett's #1 rule is, don't lose money. If you lose money, you have less to recover with, meaning for every drop you need a bigger percentage recovery to bring you back to square 1. If an asset drops 33%, you need an almost 50% recovery to recover. If an asset drops 50%, you need 100% recovery to break even. Even if the next day is a bigger rebound than what you lost the previous day, with leveraged ETFs it is still less helpful even if the recovery gets doubled because more money was lost the prior day. Value erosion builds up over longer holding periods as well.

Note that UGL, despite the 2x leverage, has not massively outperformed normal gold ETFs for these reasons.

If you don't fully understand these risks, do not proceed with a leveraged ETF. Consult a financial advisor . They are best used over short durations because of value erosion. They are highly speculative burst instruments.

Links for reference on these risks:

• The Lowdown on Leveraged and Inverse Exchange-Traded Products
• Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors
• Regulatory Notice 09-31 | FINRA.org

On the plus side, for shorter holding periods UGL does offer leverage cheaper than how much you'd need to pay in borrowing fees for a normal short. A 0.95% expense ratio is not too high in light of that. Also, some evaluating UGL may appreciate the benefits of getting access to leverage where leverage might otherwise not be permitted. However, for longer periods, other gold ETFs without leverage will offer expense ratios almost a 3rd of that, and the benefits of leveraged ETFs get diminished a lot over time

The Gold Thesis

As far as the underlying exposure goes, we are impressed with gold's performance. As a non-productive asset and with a certain degree of expense ratios associated with gold ETFs and of course custody costs for physically held gold in trusts, it has performed very well, approaching highs once again. This is in spite of the fact that rates have gone up, which gives a stronger proposition for cash over gold. The enduring performance of gold demonstrates that the secular thesis concerning greater geopolitical tension and issues may actually be applying, and with more geopolitical actors moving to destabilise trade, most recently in Yemen, we feel that the appeal of gold will endure and grow as rates also begin to fall with the Fed beginning to concern itself with the growth mandate and not just inflation. We think the Ukraine war and the movement of Russia into the orbit of more hostile powers to the West is going to be an enduring factor for heightened geopolitical tensions, and we have no expectations of things getting better from here for a while.

While gold addresses as it always does issues of greater uncertainty with the order of things, we maintain that UGL, with the peculiarities and disadvantages of daily resetting, is not a good pick, especially as gold hasn't been that correlated to the rate situation ultimately, as measured by sensitivity with higher duration Treasury ETFs, and where developments in short horizons are going to be inherently unpredictable. We are also at a height in terms of tensions in Yemen, where military action is underway to resolve issues with the passage of trade.

While a general gold ETF might be all right at this time, we'd definitely avoid the added issue of leverage and daily resetting which also cost more in expense ratios.

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