This article makes the case how prudent short-selling of inverse daily leveraged gold ETFs such as GLL could be an interesting alternative longer term strategy compared to holding unleveraged paper gold.
This is a spin-off article to my small series on the longer-term dynamics of daily leveraged ETFs. Part 1 covers the complex medium to longer term dynamics of these instruments and why buy-and-hold investors should beware. Part 2 discusses more aggressive speculative strategies of short-selling these ETFs to profit from these dynamics. This spin-off is action-oriented, so for a background I suggest reading these two articles and/or one of many others on the topic here on Seeking Alpha.
Background on GLL
GLL, the Proshares UltraShort Gold ETF, is a daily leveraged ETF that tries to track 2x the inverse daily returns of paper gold, defined as the gold bullion PM-fixing set by the London Bullion Market Association. In this article I will argue how shorting this ETF constitutes a particularly attractive alternative compared to a long position in the highly popular unleveraged paper gold ETFs such as GLD, the SPDR Gold Shares ETF. To illustrate why I will provide a brief and somewhat crude (i.e. not in any way scientifically exact) empirical simulation to make a suggestive illustration of why shorting GLL over time can evolve into a tails-I-win-heads-I-do-not-lose-as-much type trade.
Below please find an illustrative graph of GLL's actual total return performance since inception versus paper gold and versus GLD.
An illustrative 1968-2013 YTD back-test in the gold market
Based on freely available data from LBMA I took a quick-and-dirty look into what would have been the historical performance of keeping a theoretical -2x daily leveraged exposure to the LBMA Gold PM Fix, would such a vehicle been available. In this first simulation there are no frictions included, apart from the daily leverage compounding dynamics.
As can be seen from the summary table below the unleveraged long LBMA Gold PM Fix investor would have been losing money at a modest annual rate during the end of the 1960s, during the 1980s and the 1990s. On the other hand, the same buy-and-hold-investor would have had extremely attractive nominal returns during the high-inflation 1970s and quite attractive returns during the new millennium so far.
If we move over to the more complex longer term track-record of a theoretical -2x daily leveraged exposure to the same daily LBMA Gold PM Fix two things are notable. First, and perhaps most obvious, the performance of this type of leveraged position suffers greatly when the gold market moves strongly in the opposite direction, like during the gold bull market of the 1970s or during the new millennium up until today. Second, the complex longer-term compounding behavior of daily leveraged ETFs is susceptible to poor performance during periods of high market volatility. Note how during the 1980s the underlying unleveraged long position lost 3.3% per year but the -2x daily leveraged ETF shorting the same market managed to lose around four times as much per year, with a CAGR of -13.6%. Without doing in-depth analysis here this is to a large extent the effect of the daily leveraged ETFs' flawed compounding dynamics.
Simulated -2x daily
leveraged gold ETF**
Table is based on the author's simulation on freely available LBMA daily data. All metrics are based on USD returns. The author assumes no responsibility for the accuracy of this illustrative simulation.
* = Refers to the LBMA PM Fix on most days but on some half-day trading days, when there was no PM Fix, it has been replaced by the LBMA AM Fix. Positions are simulated by compounding the daily return difference between the daily fixes.
** = Based on the LBMA PM Fix (as defined in * above) this is a simulation of a hypothetical ETF that manages to maintain a constant leverage of -2x the daily returns of the LBMA PM Fix. This simulation does not take into account fees etc.
It should be added that due to potential copyright issues I will not reproduce the actual data but the interested speculator/trader should go to his/her source of long-term time series data to confirm any interesting claims made in this article. Any speculator interested in putting on positions based on the simulations in this article should recheck the results against their own data.
Friction in GLL since launch
I then extract the Yahoo Finance adjusted closing price of GLL, the ETF pursuing the strategy simulated above (a daily -2x exposure to the LBMA Gold PM Fix). By taking the daily return differentials between GLL and the "frictionless" simulated ETF above I find that GLL's daily returns, compared to the simulated ETFs, suffered from a daily (arithmetic) mean "friction" (this article employs the term loosely) of approximately -0.0229% per trading day during the period 2008-12-04 (the date of inception for GLL was 2008-12-01) up until 2013-04-26. This friction is made up in part by fund management fees but most of it arises from execution inefficiencies and associated direct and indirect costs. Note that this friction adds on top of the poor medium to longer term compounding dynamics noted above (described in depth in Part 1 and Part 2).
Adding friction to simulation
Continuing with the simulation, I now subtract a constant -0.0229% per day from the daily returns of the simulated -2x daily leveraged ETF. I then choose to evaluate the half-life of a long position in a simulated -2x daily leveraged ETF with friction to study the historical long term performance of short-selling such an ETF. In other words I study how long it takes between each sequential loss of half the nominal value for the hypothetical ETF and what are the nominal returns per time unit of pursuing a long or short position.
Below is a summary of the sequential half-life periods of such a simulated -2x daily leveraged LBMA Gold PM Fix ETF. The reader should note that the poorest performance was during the 1980s that followed the bursting of the gold price "bubble" in 1980, but in spite of >50% maximum drawdowns and unfavorable gold price development from the 1980s until the mid 2000s the short position managed to eke out weakly positive annual compounded nominal returns. But apart from the 1980s, 1990s and first half of the 2000s the performance of a theoretical short position was anything but lackluster with high to extreme (see end of 1970s) positive CAGR. In the 45 years covered in total the theoretical short position had a simulated compound return of around +14.4% per year, before associated short-selling costs.
Simulated 2x inverse daily leveraged gold ETF, with slippage
Table is based on the author's simulations on freely available LBMA daily data. This is a simulation of a hypothetical ETF that attempts to maintain a constant leverage of -2x the daily returns of the LBMA PM Fix (as defined in the previous table). "Long position" refers to the returns of such an inverse ETF while "Short position" refers to the mirror opposite returns obtained when being a short-seller of the inverse ETF. The simulation includes a friction of -0.0229% per day on the Long position, which in turn boosts the return performance of the Short position. All metrics are based on USD returns. The author assumes no responsibility for the accuracy of this illustrative simulation.
* = Maximum drawdown since start of period.
Execute with common sense
The above experiment could serve as a crude and illustrative example of the historical performance of a GLL-type ETF. It is up to the interested speculator to go deeper into evaluating the risk-return metrics of all potential variations of set-ups and trading strategies focused around a potential GLL short position.
Now moving over to real world execution there are several alternative strategies that could be employed to modify the expected risk-return profile of the short GLL trade. Myself I have not put on a short GLL trade at the moment (I do hold OTM put options on ZSL, a fund similar to GLL except that the underlying is paper silver instead of paper gold).
Strategy 1: Outright short-selling of GLL
If going for an outright short (as opposed to e.g. bought puts) it is extremely important to control the tail risk of the short position as emphasized in my second article on daily leveraged ETFs (see Part 2). You must also make sure that the units can be borrowed at attractive and predictable terms from your broker. Otherwise I would advise against an outright short position.
Practically, limiting the position size in relation to portfolio margin also limits the day-to-day effort-level required to manage the trade. When it comes to adjusting the risk-return profile of the trade, you should put a tail hedge in place.
One simple tail hedge would be executing the trade as a double-short pair trade, employing the twin mirror daily leveraged Bull/Long ETF called UGL. By shorting the GLL-UGL pair the proportion of shorted amount in GLL per shorted amount in UGL can be adjusted to accommodate a changing view on market fundamentals and/or to keep a desired tail-hedge proportion in the opposite direction. Consider adding on this short UGL-leg would gold start to move exponentially upwards and/or if tail hedging through options becomes too pricey. The interested reader can refer to the FAZ-FAS example in Part 2.
Another example (out of many) of a tail hedge would be to enter a put backspread, employing either options on XAU/USD or ETF options on GLD or similar. Selling ATM puts and buying twice (or some other larger proportion) the amount of OTM puts at a lower strike level, you can make sure to profit from both a range bound volatile market in the shorted GLL units (through volatility drag on GLL) and from a continuation of the uptrend in the gold price (essentially killing GLL quickly). And first and foremost, it will protect you short-term from most realistic price paths during sharp gold price corrections when GLL will actually be an efficient short-term compounding instrument (putting significant pressure on your short position). The put backspread options hedge can be executed as a net credit or net debit position but personally I consider this issue to be of second importance; it is more important to design the hedge in relation to the risks of the shorted GLL position. I would not mind paying up a bit if that means I could go a bit more aggressive in position sizing in GLL without fear of a margin call/blowup in a single day event.
For example, you could size the hedge so that the puts sold ATM were for around 2 times your GLL exposure at the time; if you were 5.000 USD short in GLL on day 1 you would sell XAU/USD or GLD ATM puts on the equivalent of 10.000 USD and buy XAU/USD or GLD OTM puts on 20.000 USD. If the OTM puts were placed let's say 5% below the current price of gold and gold immediately started a quite extreme 5 day plunge of 7% per day (a 30% drop in 5 straight falling days), GLL could easily gain over +100% ([1+0.07*2]^5 - 1 plus short term price/NAV increase effects due to increased demand, short squeeze etc.). You would then be down over -5.000 USD on your short GLL position.
The put backspread hedge of this size with an OTM strike 5% below the gold price at the start of the move would cover approximately 2.200 USD of this extreme move ([-10.000]*[1-0.95]+[20.000-10.000]*[1-[0.93^5]/[0.95]] until expiration of the options. But that is not considering the likely vega gains that would boost the implied volatility of your options position during this type of move. The more extreme the move the more time value you are likely to receive in the options due to the vega increase (remember after an extreme plunge you are now holding twice as many bought ITM puts as you have sold ITM puts), so modifying the position at this stage, either voluntarily or due to margin calls, could work out decently well given that the options' pricing is efficient. Alternatively, if not managing the trade intraday, the perhaps most realistic scenario is that the underlying market will now start to stabilize, putting pressure on GLL. The best possible scenario for this position after a 5 day straight gold price plunge would be a see-saw market with lots of market intervention, volatility and fluctuating trading flows, making GLL suffer while adding unrealized gains to your put backspread position (which is now ITM). If comfortable and fundamentally convinced that a bottoming out in paper gold is near this could be a good time to realize some hedging profits as GLL starts to reverse its gains (your losses) in the messy trading that could follow a plunge.
Strategy 2: Buying GLL puts
Myself I would examine and continuously monitor whether the pricing of the longest time to expiry (October 18 2013 at the moment) GLL OTM put options makes sense. In line with the simulation above the market should over time price in potential price spikes and/or periods of elevated volatility. If your analysis shows this is not factored in fully into the OTM puts that would be an opportunity to accumulate a small position.
Strategy 3: Selling GLL calls
Personally I avoid naked call option selling (given that GLL compounding dynamics could work efficiently both ways over the shorter term) but selling GLL ATM calls after/during a sharp gold price plunge could possibly be done at elevated implied volatility. Alternatively, if you believe options pricing is supportive, you could go for a controlled risk-reward call options spread.
If going for some portfolio share allocation to paper gold over the medium to longer term consider short-selling the inverse 2x daily leveraged paper gold ETF GLL, or similar vehicles, as an alternative to holding an unleveraged long gold ETF, such as GLD. Doing so you will get a leveraged long exposure while at the same time exploiting the flaws in the medium to longer term compounding dynamics present in daily leveraged ETFs.
Enter a medium to longer term GLL short position only if you have a conviction that paper gold is going to 1) trend upwards or consolidate and/or 2) when the paper gold market will trade with high volatility. In addition, short-selling trading conditions must be supportive of your strategy execution, either when it comes to short-selling the ETFs outright and/or concerning the pricing of options.
A side note on my current view on gold
My article has not yet mentioned why I or anyone else should be interested in a long (paper) gold exposure in the first place. Despite there being quite a few better informed gold market experts here on Seeking Alpha, I will just briefly outline why I am more tilted towards being medium to long term positive than bearish concerning the yellow metal.
As pointed out by well-known value-oriented investors such as Warren Buffett, gold does not constitute a productive investment asset. While I agree, under the right circumstances gold can serve as a good medium to longer term alternative to a fiat currency cash position. Fundamentally I am slightly biased towards that physical gold's longer term (nominal) price development against the US dollar will be positive, based on a cautious outlook on the current state of the globalized economy, the leverage still present in our interconnected financial system and the de facto fiat currency debasement we are seeing in the form of both quantitative easing programs and outright currency devaluation. With the U.S. still in quantitative easing mode and the U.S. dollar still the world reserve currency above all others I see no signs that hard money Austrian economists have yet managed to rally enough support to change the status quo, all we get is new names for the same money-printing. This means that the U.S. will have to play along and keep printing together with its major trading partners not to lose competitive ground or to lose track of the current policymakers' nominal growth focus (who said anything about real growth, innovation or human development?). The day the velocity of money picks up we could be in for some pretty heavy inflation if we go along with the status quo interventionist approach. Ceteris paribus, this would be very positive for gold as long as gold has not become abundant in supply and people still believe in it as a store of value.
Alternatively we will bite the bullet over the short to medium term and deleverage globally over a 5-10 year period, more likely due to a new round of financial crisis than voluntary measures, leading to painful short-term consequences which would trigger even more fear-driven investment demand for gold. In a deflation scenario gold could fall nominally in price but there should be some robust demand for the yellow metal from the squeezed parties who will substitute almost whatever failing asset they can for hard and easy to move assets, e.g. gold. Whether the paper gold market would survive this type of event is less clear to me but as long as the system itself is not allowed to break down completely odds are positions would be bailed out if major members of the exchanges themselves are at risk of defaulting.
That said I am not a hardcore gold bug and I do not expect any doomsday ahead, but after gold's price increase lost momentum I came to the conclusion that going forward I am going to keep some percent long portfolio exposure to the gold and/or silver paper market as a hedge against potential continued fiat currency debasement. Gold has already seen a decade-long bull run so I do not naively believe it will necessarily continue exponentially upwards without major corrections. At the same time volatility in general is rather suppressed which opens up the possibility that strong gold price corrections will be associated with at least some periods of strong see-saw action if market interventions continue for the near to medium term future. The recent gold and silver market action looks promising in this respect.
Additional disclosure: I am short ZSL through OTM put options.