Triple-Leveraged ETFs Store Up Trouble for $8.5 Billion Fund

(Bloomberg) -- Trouble in the leveraged ETF complex could spark a fresh volatility explosion that hits commodity investors in its wake, according to Macro Risk Advisors.

The New York-based firm warns the VanEck Vectors Gold Miners ETF, ticker GDX, is vulnerable to outsized price swings if its tracked basket of stocks drops by 5 percent or more in a single day.

The culprit: two triple-leveraged ETFs divesting their GDX shares en masse, roiling the $8.5 billion fund in the process.

Sound familiar? It should. A similar feedback loop amid a frenzy of ETF rebalancing took place in February, when products tracking VIX futures were blamed for intensifying the volpocalypse.

Should a similar dynamic engulf GDX, it would shine a fresh light on the complex machinery behind leveraged and inverse products that buy and sell the underlying assets in order to deliver an amplified version of the moves, or the opposite result.

“The selling can beget further price declines which can beget more selling,” Dean Curnutt, chief executive of MRA, wrote in an email.

The Van Eck fund has become one of the most heavily traded ETFs in the world thanks to its reputation as a high beta play on gold. It tracks a global index of miners, with a large allocation to North American companies such as Newmont Mining Corp. and Franco-Nevada Corp. The fund has tumbled over 8 percent this year, as dollar strength undercuts gold prices.

While gold volatility is low, an uptick in U.S. inflation-adjusted yields as the Federal Reserve raises rates and a stronger greenback could exert more pressure on bullion.

The product's largest one-day drop over the past year was in February at 3.3 percent, according to data compiled by Bloomberg.

Feedback Loop

In the event it falls 5 percent, two leveraged funds from Direxion, a firm specializing in geared and inverse instruments, would be forced to sell 28.6 million shares in the gold miner ETF in total, MRA said. That's more than three-quarters of GDX's trailing 30-day average volume, according to data compiled by Bloomberg.

All told, the rebalancing wave could spur a jump in the ETF's volatility and drag its price ever lower, in a tail-wagging-the-dog dynamic, according to the risk-advisory firm.

The funds in question: The Direxion Daily Gold Miners Index Bull 3x Shares, ticker NUGT, and the Daily Gold Miners Index Bear 3x Shares, DUST, which have seen their combined assets rise in recent years to $1.5 billion. NUGT is the single largest shareholder in the Van Eck fund -- as of July 26, it held 32.8 million shares, worth $715.9 million.

“Forced selling of this magnitude would have the potential to cause a spike in realized volatility in GDX,” MRA said in a recent note.

Conversely, a dramatic gain in the Van Eck fund would force both leveraged ETFs to buy shares to rebalance. If they didn't, their daily leverage would veer from the advertised level. Representatives for Van Eck and Direxion either declined to comment or didn't return requests for comment.

One new ETF, wary of the pitfalls that can trip up these products, is plotting a different course in order to deliver high returns that are typically associated with leverage, without the use of borrowed money or derivatives.

The Salt truBeta High Exposure ETF tracks an index of about 100 equal-weighted stocks that have high sensitivity to market moves. The $3 million fund is down 1.5 percent since it started trading in May.

“That was the challenge we wanted to unravel -- how do you create a product that gives the benefits of leverage without the side effects?” Alfred Eskandar, president of New York-based Salt Financial, said at the fund's launch.

To contact the reporter on this story: Yakob Peterseil in London at ypeterseil@bloomberg.net

To contact the editors responsible for this story: Samuel Potter at spotter33@bloomberg.net, Sid Verma, Cecile Gutscher

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