Tuesday, August 4, 2015

When Investing In The Leveraged ETFs - Be Aware Of Simple Mathematics

Many investors invest in ETFs (Exchange Traded Funds), which are special investment vehicles designed to make it easier to invest in specific asset classes. Some of these vehicles are highly-leveraged ones. Let me take, as an example, two precious metals ETFs: GDX and NUGT.

GDX is called the Big Gold ETF because its price mirrors prices of a number of big gold producers and royalty companies - the main ETF holdings are such companies as: Barick Gold, Newmont Minng, Goldcorp, Franco-Nevada, Silver Wheaton etc.

This ETF has its highly leveraged equivalent, holding a ticker NUGT. NUGT duplicates the price action of GDX but a price change of 10% reported by GDX is equivalent to 30% reported by NUGT (so NUGT is 3 times leveraged against GDX).

And here is a catch. Due to this high leverage and simple mathematics, investing in NUGT has sense only when we see a strong bull market in precious metals. If the market is trading in a range, or is going down, investing in NUGT may bring a financial catastrophe.

Let me show it using numbers. Below you will find a chart showing investment results delivered by GDX and NUGT when market is trading in the range. I assume that at the end of the second trading day GDX losses 10% (and NUGT losses 30%). The third trading day records a 10% price advance (NUGT goes up 30%). Then GDX goes down by 10% etc. The results are below:

As the chart shows, after 19 days, GDX stands at 91.4 and NUGT at 42.8. So the total loss recorded by GDX is 8.6% but NUGT is as much as 57.2% down (not, as somebody would think, 3 times 8.6% but much more)! Generally nothing happened during these 19 days - market is more or less at the same point where it was in the beginning but NUGT has lost nearly 60%.

If market is going down, the losses reported by NUGT would have been even much bigger.

So, summarizing, investing in NUGT (and any positively leveraged ETF) only makes sense when market goes up. Be aware.

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