The Risks of Shorting Metals with Inverse ETFs

Gold drops as the Fed comes through with big rate hike

Gold dropped -1.6% this week to US$1,645/oz as the Fed came through with a 75 bps hike as expected, making it clear that the Fed was not backing off its attack on inflation, even in light of already severe fallout in the economy and equity markets.

ETFs to short the metals other markets work mainly short-term

This week we look at inverse ETFs, including those for metals, which can theoretically be used to profit as markets decline, but show they are effective mainly only very short-term, and that for most of these instruments tracking error is a major issue.

Producers and juniors down as gold and equity drop

The producing and junior gold miners were both down this week with the GDX declining -6.5% and GDXJ falling -7.8% and the large cap TSXV gold stocks were nearly all down on the slide in both the gold and equity markets.

The Risks of Shorting Metals with Inverse ETFs

Gold was down -1.6% to US$1,645/oz as the Fed came through with an expected 75 bps rate hike, sending its Effective Funds Rate above its pre-crisis high of 2.41% in March 2019 (Figure 4) and to its highest level since the global financial crisis in 2008 (Figure 5). It made it clear that the Fed will continue to attack inflation even with abundant fallout already in the US economy and equity markets. The US rate hikes are also becoming an increasingly global problem as the US$ continues to surge and other world currencies are relatively devalued, increasing their import costs even as they deal with high domestic inflation. While some balance could on the currency side could be returned by the rest of the world hiking rates, this could further curb economic growth and send down global equity markets even more. The main hope now is that the rate hikes and economic slowdown will drive down inflation, although this may not come through until well into 2023. For now, inflation remains high, economic growth is slow and gold and equity markets are declining, a combination which is obviously not very supportive of gold miners, especially the riskier juniors.

Gold and silver holding up relatively well, but metals stocks mostly down in 2022

We can see these negative effects quite clearly in Figure 6, showing the performance of metals, metals ETFs, equity markets, the US$ and crypto in 2022. The US$ is the biggest, and only, winner this year, up 17.4%, with even the second and third best performers, gold and silver, still down -8.6% and -17.4%, respectively. While the MSCI Global Metals and Mining Index is down -20.9%, it has outperformed both the S&P 500, down -23.0% and the MSCI World, down -24.7%. While copper has underperformed gold and silver, down -24.2%, copper miners, up 25.2%, have surpassed both producing and junior gold and silver miners, which are down between -28.2% and -38.3%. The worst performer by far, however, has been cryptocurrencies, which have seen a -57.0% drop in their market cap this year, as several major coins saw large declines and many coins dropped near zero in value.

Shorting with inverse ETFs only intended to work on the day

With such a difficult year so far, and a high potential that declines could continue, with the Fed showing no signs of pulling back and rate hikes potentially going global global, investors may understandably be considering ways to short markets, including the metals, at this point. The easiest instruments through which this can be done are Inverse ETFs, which target the negative return of a given an index, usually over a single trading day. If the index returns 1.0% on the day, the Inverse ETF would return -1.0%, and if the index declines -1.0%, it would return 1.0%. Inverse ETFs can be found for many markets and sectors globally, and can also be double or triple inverse, targeting returns for example on a 1.0% gain in the index of -2.0% or -3.0% and appear interesting in the case of down markets.

For the metals markets, the options for Inverse ETFs are mainly limited to gold and silver, with no specific ETFs available for the miners directly, with two main companies, Proshares and Direxion having these instruments available on major markets. Proshares and Direxion do not offer a single inverse ETF for gold or silver, only double, and Direxion also offers triple for silver. There is a third company, Velocity, offering a similar product but only from over-the-counter markets, providing more limited liquidity and pricing. On September 23, 2022, with gold down -1.14%, the theoretical two times inverse return is 2.29%. However, the Proshares 2x Inverse ETF returned 3.57% and the Direxion ETF 10.27%, both well above what would be expected. We see a similar issue with silver, with a decline on the day of -3.60%, but the double and triple inverse ETFs returning well over the expected levels of 7.21% and 10.81%, respectively, and actually returning 8.53% and 12.18%.

Tracking error a major issue for inverse ETFs even for short periods

This highlights the problem with these ETFs, which is tracking error, with the companies offering the ETFs using derivatives to achieve their target returns, and market swings often making hitting these targets difficult. While in this example, the tracking error is actually in investors favor, this is often not the case, and the tracking error can also move heavily against an investor on a given day. The other issue is that the tracking error will compound over time, with these divergences from the expected return, which we can see can be very large even on a given day, getting increasingly larger. This means that if we see a -10.0% decline in the underlying metal over a month or more, for example, while we might expect a double inverse ETF to return 20.0%, the actual returns will generally be far from this level. The providers of the inverse ETFs are very clear in their documentation that the target return is only for a single day and that their instruments are extremely risky.

We check the tracking error for these instruments over a longer period, from the start of 2022, in Figure 8. For Proshares double inverse ETF, the tracking error is actually quite low, even over this much longer period, with gold down -8.2% and the instrument up 17.2%. However for Direxion, we again see a major divergence, with the instrument up 45.4%. Again, while this a good outcome in this case, this tracking error can just easily move against the investor. We see this more in the silver inverse ETFs, with a 34.8% and 52.1% theoretical return, for the double and triple ETF, respectively, but the actual returns at just 26.2% and 31.6%, showing how tracking error reduces returns over time.

There are many inverse ETFs beyond just gold and silver, offered on oil, other commodities and many other sectors, and these instruments focused on subsegments of markets tend to have quite substantial tracking error over time. There are two Inverse ETFs that do seem to track relatively well, even over long periods, but they are not on individual metals markets. These are the Proshares SH and SDS ETFs, targeting single and double inverse returns on the S&P 500, although even these do face some tracking error over longer periods.

Starting from a year ago until the end of December 2021, the S&P is down 7.2%, and the single inverse ETF returns -7.8% and the double -15.2%, so close to the expectation, even over a relatively long period (Figure 9). However, within a year we see the ETFs diverge quite a bit, with gold down -16.9%, but the single inverse returning only 13.6% and the double only 23.7%, versus an expected 33.8%. This shows again how tracking error can curb returns over longer periods, even for instruments with a relatively low tracking error like the SH and SDS, because of the liquidity of the S&P 500 and the wide availability of derivatives on this index.

Bear market rallies another issue

Beyond the tracking error issue inherent to the fundamental function of the Inverse ETFs, is the more random swings of the metals and overall markets, and timing them in a downturn. Bear markets do not go down in an orderly fashion, and encompass many rallies, as shown in Figure 10. In the S&P 500 bear market from January 2000 to December 2002, there were four major rallies of over 10.0%, each over a relatively short time period, and entering a single, but especially double, Inverse ETF trade just before one these rallies could have generated substantial losses. Even the more abrupt market collapse from mid-2007 to mid-2009 had two rallies of more than 10%, and another over 4.0%, which could have driven significant losses for an Inverse ETF position made just before the upswings. For the metals, the gold bear market from 2012 to 2016 had four rallies over 10.0% and one over 8.0%, which again would have led to severe losses if an Inverse ETF position was timed poorly just before these rallies.

Inverse ETFs mainly for aggressive short-term traders

So while it might be tempting to look towards Inverse ETFs on metals markets given the major downturn in 2022, which we do acknowledge could continue through the rest of year, the combination of tracking error and timing issues makes them a 'nuclear' option. While they could be fine for very short-term traders with especially high-risk tolerance, for the typical investor, they might be best avoided. As ever, we see the current markets as a time to hold back and research attractive junior mining stocks for eventual bargains that could be arising as early as next year as valuations continue to come down for many companies with strong operations.

Producing gold miners nearly all down as gold and stocks fall

The producing gold miners were nearly all down as gold and stocks declined on the Fed's 75 bps rate hike (Figure 11). Newmont and Yamana both reported on Glencore's acquisition of Newmont's 18.75% stake in the MARA project, increasing its holding to 43.75%, with Yamana holding 56.25% of the project. B2Gold reported that it had completed the acquisition of Oklo with 10.7 mn B2Gold shares and A$24.7mn in cash and SSR Mining received regulatory approvals from Turkey's government to restart all of its operations at the Copler mine, which led to it being the only major producing miner to see share price gains this week (Figure 13).

Large TSXV gold juniors decline on gold and equity market drop

The larger TSXV gold juniors mostly declined on the drop in both gold and equity markets (Figure 12). For the Canadian juniors operating mainly domestically, Artemis began site works at Blackwater, with the start of major works construction expected by Q1/23, Tudor Gold closed a $7.75mn private placement with Eric Sprott subscribing for $2.0mn and Laurion began a joint evaluation with DRA Americas to monetize assets at Ishkoday and upsized its previous announced private placement to $2.05mn (Figure 14). For the Canadian juniors operating mainly internationally, Rupert Resources reported an exploration update and Lion One announced a C$12.5mn bought deal private placement (Figure 15).