JNUG Stock: Direxion Daily Jr Gold Miners ETF Could Soar If This Happens

JNUG StockDid you ever take a friend to the racetrack, someone who had never placed a bet before, and the first thing they want you to do is identify the longshot? That is the object of this exercise. Using sophisticated stock scanning software, I went looking not merely for a longshot pick for 2016 in the gold sector, but a longshot that actually made sense based on fundamentals as well as technicals. What I found was the Direxion Daily Jr Gld Mnrs Bull 3X ETF (NYSEArca:JNUG). In fact, I think JNUG stock could be the longshot pick for 2016.

JNUG Stock—What Exactly Is It?

First and most important, this is a synthetic or derivative investment instrument that follows the rules and guidelines for exchange-traded funds (ETFs) as regulated by the Securities & Exchange Commission (SEC). (Source: “SEC.gov | Exchange-Traded Funds (ETFs),” SEC web site, last accessed January 20, 2016.)

Think of an ETF as a shopping bag. There are hundreds of ETFs, but no two are exactly the same. Inside each shopping bag is something unique, something that is usually composed of other things, such as, for example, shares of an actual company or a combination of shares from different companies. The shopping bag can also contain options, futures, options on futures, cash, and just about any derivative or custom instrument you might think of, assuming the prospectus of the ETF permits it.

Even by the standards of a normal ETF, however, JNUG is especially unusual. According to the prospectus for JNUG ETF, the fund managers are at liberty to include virtually any form of financial instrument they wish in order to achieve the stated purpose of the fund.

What is that purpose? The stated purpose of JNUG is to replicate to a factor of three times (i.e., 300%) the market performance of the index fund known as the Market Vectors Junior Gold Miners ETF (NYSEArca:GDXJ)—which is itself a separate and unique ETF that is mandated to duplicate the performance of a specific and proprietary metric known as the Market Vectors Global Junior Gold Miners Index—on a daily basis.

Let’s Recap Because This Is Complicated!

It is easier to understand this play if you work from the bottom up.

At the foundation level, you have a proprietary and trademarked index called the Market Vectors Global Junior Gold Miners Index. It is designed, as best as possible, to reflect the performance of the junior (i.e., still exploratory in many cases) mining sector, worldwide.

The stated scope of the index itself is to include representative junior mines that “generate at least 50% of their revenues from (or, in certain circumstances, have at least 50% of their assets related to) gold mining and/or silver mining or have mining projects with the potential to generate at least 50% of their revenues from gold and/or silver when developed.

On top of that unique index, you have a specially purposed ETF or fund that is mandated to, as much as is possible, replicate the performance of it (the index) by investing “at least 80% of its total assets” in the securities that comprise the index. This is the Market Vectors Junior Gold Miners ETF or GDXJ.

Still more! On top of that ETF, you have yet another ETF that, according to its prospectus, “seeks daily investment results, before fees and expenses, of 300% of the performance of the Market Vectors Junior Gold Miners Index.” It, too, is mandated to invest at least 80% of its assets at all times in securities that comprise the underlying index. This is our core play, our longshot pick—the Direxion Daily Jr Gld Mnrs Bull 3X ETF, traded under the symbol “JNUG.”

So, by playing JNUG, you are using leverage to play GDXJ, which is itself playing the underlying proprietary index, which is essentially a fully managed basket of worldwide junior golds.

How Do Leveraged ETFs Work?

Before we go any further, we need to stop and look at how a leveraged (in this specific case, a three-to-one, or 300%, leveraged) ETF differs from a simple ETF.

A basic or non-leveraged ETF is easy to understand. For example, if there are 10 companies in an index the ETF follows and you have a dollar available to invest, you would divide the cash available among the listed index participants, all else being equal, and invest $0.10 in each.

Of course, this is a highly simplified example that does not allow for the differences in capitalization and share structure of the underlying firms; the occasional rebalancing of the companies that comprise the index itself by the index manager; the daily rebalancing of the ETF’s actual assets by the fund manager (based on both the market performance of the underlying assets as well as buys/sells of the fund itself, which is explained below); the payment of taxes and fees; and so on.

In fact, the actual day-to-day rebalancing of any ETF is fairly complicated, which is arguably the reason why most ETFs have internal fees (additional costs to the investor on top of normal brokers’ fees and transaction fees) in the first place. The current fee for JNUG is 0.95%, which means that once a year, regardless of everything else, win or lose, up or down, your investment takes a 0.95% hit.

Pumping ETFs with Steroids

Leveraged ETFs are basic ETFs on steroids. They deploy borrowed capital and synthetic instruments (index futures, equity swaps, equity options, index options, whatever they need) to achieve their goal. The typical holdings of a leveraged index fund would be a large amount of cash invested in short-term securities, plus a smaller but highly volatile portfolio of special derivatives. The cash is used to meet any financial obligations that arise from losses on the derivatives. Once again, the real engine of the leveraged ETF is the daily rebalancing.

Suppose a double-beta fund (i.e., a fund mandated to perform 200% on the metrics of the underlying assets) has $100 million of assets on a given day and $200 million of index exposure. The index rises one percent on the first day of trading, giving the firm $2.0 million in profits. (Assume no expenses in this example.)

The fund now has $102 million of assets and must increase (in this case, double) its index exposure to $204 million to maintain its leverage ratio, which in this case is 1:2. Maintaining a constant leverage ratio allows the fund to immediately reinvest trading gains.

This constant rebalancing is how the fund in this example is able to provide double the exposure to the index—or leverage—at any point in time. Without this rebalancing, the fund’s leverage ratio would change every day and the fund’s returns, as compared to the underlying index, would be unpredictable, appearing a little wonky from the investor’s viewpoint. The stated goals of the ETF simply would not be met.

What Is the Reward-to-Risk Ratio?

The reward-to-risk ratio (R/RR) has been and still is considered perhaps the top criteria the pros look at when picking an investment. (Sometimes this is called the risk-to-reward ratio, which is essentially the very same thing, but with the numerator and denominator reversed.)

It also is not as simple as it looks.

Say, for example, you have a low-yield government bond under consideration. The risk is low (almost non-existent), but so is the yield. So, in this example, low reward (yield) over low risk generally yields a R/RR of around one. In other words, reward and risk (the numerator and the denominator) are about equal on a relative basis.

Similarly, consider a lottery ticket. Very high (crazy) potential reward over equally high potential risk (i.e., you could lose the entire investment in the blink of an eye or you could make enough in the same instant to retire for life!). Bizarrely, this investment also has a R/RR value of one. Once again, reward and risk, even when at extremes, are about equal.

A R/RR of one is therefore considered normal. In fact, to take this a step further, a R/RR ratio of one is actually expected if Mr. Market is doing his job.

Think of it this way: if the ratio is one for all investments, then the only remaining variable must be price. And price is what the market is really all about, which is why people trade the market in the first place, because they presumably have confidence that investment price (or “price discovery”) is the true indicator of the risk and reward in every investment offered for sale. And that indicator, theoretically, is already factored into the investment.

But here is the rub: what if Mr. Market makes a mistake? This happens a lot. What if the price is not a true reflection of the R/RR. Or, conversely, what if the R/RR is not one (i.e., it’s higher or lower) and the market has not compensated for this via price discovery…yet?

Mispriced Stocks—The Holy Grail of Trading

In theory, the first thing a sophisticated investor asks is “why should I tie up my money in an investment with a R/RR of only one when there are potentially investments out there with a higher R/RR?” That is, there may exist mispriced investments where the R/RRs are greater than one (more possible reward relative to the known risk) and therefore selling at a relative bargain to the price asked.

Makes sense. If you have a dollar to spend and two investments to look at—one of which is mispriced by the market because the potential rewards are relatively higher than the risk, but the asking price does not yet reflect that fact—you would gravitate, all else being equal, to the mispriced investment, assuming the error is in your favor…

These investments actually do exist. The trick, of course, is finding them.

How the Pros Make Their Money

Another illustration: consider what happens in a carry trade investment where professional traders pick up money at a favorable rate (e.g., at a rate of zero from a jurisdiction imprudently implementing a zero interest rate policy, or ZIRP) and immediately re-invest the cash. They re-invest it in the safest (lowest risk) investment they can find offering a near-guaranteed return above what they paid for access to the cash originally—in this case, literally any return above zero qualifies since the original cash cost them nothing.

Here, in this example, the return or reward exceeds the risk even if the investment chosen is an extremely conservative low-yield bond—because the money being placed at risk had zero cost. The return on the investment, while seemingly low, is virtually guaranteed. So here the R/RR is actually greater than one and therefore, the trade is much more desirable. Professional traders love any trade where the R/RR is better than the typical ratio of 1:1. It puts a big smile on their faces. (Which is why they also love cheap money policies like ZIRP and QE, but I will save that story for another day.)

Why “Crazy Risk, Even Crazier Reward” Makes Sense

Let’s start with the chart below that shows the value of one unit or share of JNUG stock in 2013 and the current value in 2016. Note also that JNUG was launched in October 2013, two years after gold hit a high of $1,900 an ounce. At the time of JNUG’s launch, gold was trading around $1,400.

JNUG Chart

So what is the potential reward from here? If the investment should reliably return to its glory days in late 2013, that would be a potential return (reward) of about 7,670% from current levels or a return of a little more than 75 times the capital put at risk.

So, what about risk? To understand the risk associated with JNUG, we need to first understand three things: what assets underlie the investment, what factors mitigate risk, and why it collapsed in the first place.

What assets underlie JNUG stock? The companies underlying JNUG (we touched on this above) are the very same companies underlying GDXJ: junior golds. These are serious companies—as serious as a junior gold can be, anyway—all currently listed, exchange-compliant, traded, and all still considered potentially viable within their sector as defined in the prospectus.

The fund managers of GDXJ select, balance, and generally police these companies on a daily basis, as per the stated criteria for that ETF. That daily management is a risk mitigator.

Over the history of the GDXJ index, the underlying companies have generally represented about 50 different components inside the basket with a combined asset value usually in excess of $24.0 billion. That is a solid number and constitutes yet another risk mitigator.

Note also that the fund is worldwide in scope, thereby minimizing geopolitical issues—yet another example of risk mitigation. This chart shows the typical global distribution of the assets in GDXJ as at the most recent quarter, indicating 48 components spread over eight jurisdictions, with the bulk of the allocation to be found in Canada, the U.S., and Australia.

Country Components Weight
Canada 30 65.46%
Australia 7 16.11%
United States 4 5.98%
Jersey 2 4.85%
Cayman Islands 2 2.33%
Bermuda 1 2.22%
South Africa 1 2.01%
Turkey 1 1.04%
Total 48 100.00%

Data source: Market Vector Indices

What about liquidity, yet another potential risk mitigator? GDXJ trades on average over eight million shares a day. JNUG, which leverages off GDXJ, is itself highly liquid, trading about one million shares a day. Should sentiment shift again and investors become re-engaged in the gold sector, the daily volume for both ETFs would presumably increase even more.

So, that is what underpins the JNUG play and mitigates risk: assets, liquidity, geographical distribution, and daily management by the fund.

Next, what actually happened to JNUG (and, correspondingly, GDXJ) from 2013 to the present? Usually an investment with that kind of chart action would have declined so precipitously only if something catastrophic had occurred. In other words, typically this sort of drop is associated with fundamental bad news for a firm, such as bankruptcy or a lawsuit, a loss or negative recalculation of a major asset, the loss of critical officer, government intervention, a natural disaster, Force Majeure, etc.

In the case of JNUG/GDXJ, however, nothing like that actually happened to the underlying assets.

Essentially—simplifying a bit here—you have a sector that had to deal with an overall 40% drop in the price of gold from the 2011 high; moreover, the bulk of that drop took place during a very dramatic and historically unprecedented gold selloff in April 2013. Note that these factors constrained the ability of working gold mines generally to show a profit but did not eliminate profitability completely.

These events, in turn, led to unprecedented medium-term investor negativity (literally, the most negative sentiment since they began keeping records), which, in turn, led to the decimation and brutalization of the junior mining sector. Multiply the decimation at the GDXJ level by 300% (the built-in beta) and you will end up, approximately, with the horrific technical damage that you see staring at you in the JNUG stock chart.

Did the assets disappear or vanish? Speaking generally, no, the assets that underpinned the 2013 valuation, allowing for the daily rebalancing, are still there! As explained above, the collapse was almost exclusively due to structural changes in the sector, based mainly on the fall in the price of gold itself and followed by a corresponding collapse in investor sentiment.

So—and this is the key to the R/RR analysis—although the risk remains high (as indeed is always the case with junior mines; it is a basic fact of life that not all of them will make it to production), the risk is still less, relatively speaking, than the potential reward, assuming a full or partial retracement to the old highs.

In my view, therefore, you are here considering, potentially extremely high reward in return for merely high risk. In other words, the R/RR, while clearly at extremes of both numerator and denominator, is still above one. That is a true longshot pick for 2016. In this specific case, a 75-to-one longshot.

Hey, What About the Fundamentals?

Every investment also reflects fundamentals. Here, the two big questions are:

1. Will the gold bear end?

2. If gold reverts to its fair market value, would that be higher or lower than the $1,400 range that accompanied the 2013 high in JNUG?

It is a pretty safe bet to suggest that the current gold bear will end because the data tells us that every prior gold bear in history has ended in a gold bull market. The date, the timing, may be uncertain, but the event itself is almost a certainty.

As for the fair value of gold, there is an awful lot of debate about that. There is no single metric that everyone agrees on. Nonetheless, it has been shown that, from approximately 1990 to 2011, the price of gold faithfully followed the expansion of central bank balance sheets worldwide (adjusted for gross domestic product) on a fairly linear basis.

In 2011, however, “something strange” happened to this once-reliable pattern and the linearity snapped. The argument goes, were gold to once more reflect a metric that represented the worldwide central bank balance sheet explosion (money printing), then gold should right now be trading at about $2,500 minimum, or considerably above the pricepoint that triggered the old high in the GDXJ and, correspondingly, JNUG. (Source: “Gold’s Fair Value,” Zerohedge July 29, 2015.)

Alternatively, another credible metric that has been around for over a century pegs the value of an ounce of gold to the price of one custom-made “Savile Row” suit. By that valuation, an ounce of gold should be no less than $4,000. Again, this is a number very substantially above the level that triggered the old highs in GDXJ/JNUG. (Sources: “The GQ Savile Row Guide,” GQ.com, last accessed January 15, 2016; “The value of one ounce of Gold is equal to a handmade suit,” Kitco, September 7, 2013.)

A final potential yardstick would be to consider the possibility that those essayists who are talking about a coming “Big Reset” to the global financial system are correct. Understand that we are not talking about myths and speculation. At least one of these writers, Willem Middelkoop, actually attended a “secret” meeting in China on this topic, with central bankers from all over the world in attendance. Middelkoop learned that these meetings are ongoing, regularly scheduled, and rotate from country to country.

Governments and their bankers are moving definitively toward a reset, which will, no doubt, ultimately take the rest of the world by surprise. Middelkoop states categorically that an upward valuation of gold is an integral part of the planned reset. Timing is not clear, but the result is. Gold will see a valuation of at least $3,000, he suggests. Possibly much higher. (Source: “Willem Middelkoop: ‘No need to reinvent money’,” YouTube, October 1, 2015.)

The Bottom Line on JNUG?

I warned you this was not a simple investment. It is in a sector that is very hard to love; recent performance is unsettling; and, as a derivative on a derivative on a proprietary index, it is hard to fully understand.

Nonetheless, I believe JNUG stock meets all the criteria for an ultimate longshot pick in 2016, with underlying managed assets of substantial capitalization, significant risk mitigators, intriguing fundamentals, built-in leverage, and a conceptual R/RR above one.

This is a longer-term trade with a multiyear time horizon. Check it out yourself.

Sponsored Web Content