Gold is off to a strong start in 2020, so it can be tempting for gold investors to try and boost gains. Wall Street offers a variety of financial instruments that promise to double or even triple the returns of gold. While real gold protects investors, these leveraged gold products can be even more dangerous than using leverage in the stock market.
The first issue is performance. Unfortunately, Wall Street's leveraged gold does not work the way that many investors expect. A 2x gold ETF or ETN uses leverage to double the daily gains and losses of gold rather than its long-term performance. These financial instruments are for short-term traders who jump in and out of the market, not long-term investors.
One big catch comes from the way that the gold price moves. Bull markets are more stable in the stock market, but the gold price is unstable when it is going up. That means annual gains for leveraged stock ETFs during bull markets will usually be even greater because of compounding. Rather than compounding, leveraged returns for gold will often be lower because of volatility. 2x daily returns frequently lead to less than 2x annual returns for leveraged gold.
It helps to take a look at some examples. The S&P 500 ETF SPY went up by 31.29% in 2019, and the 2x S&P 500 ETF SSO rose by 63.75%. The 2x stock ETF more than doubled the returns of stocks. Gold also had a good year, with gains of about 18.83%. However, the 2x gold ETF UGL increased in price by 32.56% in 2019. You can see that the returns of leveraged gold last year were substantially less than double those of real gold. UGL also lost nearly seven percent in 2018, while the gold price fell only about one percent.
It is also useful to remember why the gold price rises. Gold isn't actually going up. Instead, the price of U.S. dollars in terms of gold is falling. Bull markets in gold are really bear markets for the dollar. The instability of the gold price comes from measuring it in declining paper dollars.
That brings us to the most important reason for avoiding leveraged gold ETFs and ETNs. While 2019 was good for almost all asset classes, some of the best years for gold come during market meltdowns. Using a leveraged financial instrument in the middle of a financial crisis is a terrible idea. You could lose your entire investment if the company underwriting an ETN goes bankrupt.
Protection from financial disasters is the real reason for investing in gold. If you want to increase gains, buy an out of the money call on a gold ETF or ETN. When safety is a concern, no Wall Street financial instrument can ever compete with physical gold that you hold directly.