Gold ETNs Provide Case Study In Monthly Leverage

After months of steady appreciation, gold has been on a bit of a wild ride over the last week or so. The precious metal has climbed to new heights repeatedly in 2011, thriving off of rising anxiety surrounding global equity markets, flights to safety after unprecedented downgrades, and even some weakness in the U.S. dollar. But last week gold encountered a rather rough patch that lent some credence to the notion that prices have inflated to bubble levels over the last few months. Investors fled gold ETFs in droves, taking profits generated during the run-up and jumping back into risky assets that have been battered by the wave of general risk aversion.

Last week’s dip in gold prices also highlighted some of the nuances in the various exchange-traded products that offer leveraged exposure to precious metals. In particular, a pair of 2x leveraged ETNs linked to indexes comprised of gold prices experienced what appeared to be some bizarre movements. The returns of the PowerShares DB Gold Double Short ETN (DZZ) and PowerShares DB Gold Double Long ETN (DGP) generally experience movements of similar magnitudes, but in opposite directions. Last week, that wasn’t the case; DZZ’s gains exceeded DGP’s losses by a wide margin as gold prices plummeted, and the former turned in gains that represented well more than 200% of the slide in the spot price of the precious metal:

Date	GLD	DGP	DZZ
8/23/2011	-3.7%	-6.5%	+12.7%
8/24/2011	-3.4%	-6.2%	+10.4%

Under the Hood: Monthly Leverage vs. Daily Leverage

Last Tuesday, DZZ’s gain was more than three times the decline in spot gold prices, and nearly twice the level of the loss incurred by the double long ETN. At first glance, it may appear as if these products are performing erratically and unpredictable. But in reality, DGP and DZZ acted just as they should, and the performance discrepancies were attributable to the nuances associated with the frequency in resets of the leveraged exposure.

Both of those ETNs seeks to deliver amplified results of an index comprised of gold futures over the course of a month, meaning that the 2x target multiple is only applicable for investors who buy in at the initial leverage reset (i.e., the beginning of the month). Depending on the movement of the underlying asset during the course of the month, the effective leverage experienced may change, and can sometimes change dramatically. As gold prices climbed steadily higher – GLD had gained almost 17% before last week’s pullback – the sensitivity of DZZ to gold prices shifted from 2x towards almost 3x. Conversely, DGP’s sensitivity to changes in spot prices diminished as the precious metal crept higher, which resulted in the movements last week of less than 200% of the underlying benchmark.

Here’s a simplified example. Suppose that a 2x monthly leveraged ETN started the month at $100, and the underlying index added 10% by the middle of the month. Investors who buy in at the $120 level mid-month are actually experiencing leverage of less than 200%. If the index gains another 10%, bringing the monthly total to 21%, the leveraged ETN would finish up at $142. For those who bought in at $120, that represents a gain of about 18%–less than 200% of the change in the underlying index.

The same phenomenon works in the opposite direction. As prices tumble (as was the case for DZZ), sensitivity can increase quite significantly.

Details of Leverage Net 10%

The frequency of leverage resets may seem like a minor detail when selecting a leveraged ETF. But the performances of products offering amplified exposure to gold over the last week demonstrate that minor details can sometimes have a big impact on bottom line returns. During those two days, DZZ surged by about 24.4%. The ProShares UltraShort Gold (GLL), which seeks daily results that correspond to -200% of the daily movement in gold prices, was up about 14.5% during that same period. Both of these products offer 2x leveraged exposure to gold prices. And both functioned just as they should during the big two day sell-off last week, efficiently accomplishing their stated objectives. The big gap in performance between the two – returns varied by about 10% – was a result of the reset frequency of the leverage offered, and the ramifications that detail has on the effective leverage offered at various times.

These differentials are yet another reason why it pays to take a look under the hood of any potential ETF or ETN investment and get a grip on the factors that will impact performance. Sometimes the little details go a long way, as evidenced by the significant return differentials between products that may appear on the surface to be quite similar.

Disclosure: No positions at time of writing.

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