Scotia’s levered notes on gold miners ETF may only help in a sideways market, contrarian says

By Emma Trincal

New York, Dec. 18 – Bank of Nova Scotia’s plan to price 0% Accelerated Return Notes due February 2022 linked to the VanEck Vectors Gold Miners exchange-traded fund may appeal to investors only mildly bullish on the fund, said Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

The payout at maturity will be par of $10 plus 300% of any increase in the ETF, capped at par plus 30% to 34%. The exact cap will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

Investors will be exposed to any decline in the ETF’s share price.

Kaplan said the underlying fund was “overpriced,” but the 14-month maturity gave the investment a chance to win at the condition that the volatile fund appreciates within limits.

Since August

“I do plan to buy GDX sometime in 2021. Not now. People bought it in the summer and it’s too high at the moment,” he said.

The VanEck Vectors Gold Miners ETF, the best-known gold miners fund, trades under the ticker symbol “GDX.”

Kaplan said he placed orders to buy the ETF at 20% lower than today’s price.

The ETF closed at $36.58 on Friday, a price that is 126% higher than its March low of $16.18.

“Recently GDX made a lot of lower highs, which is a bearish signal,” he said.

The ETF peaked in August at $45.78.

“The peak on Aug. 5 was not just the high for the year but the highest point since November 2012,” he said.

The fund peaked at the time because gold had just hit the $2,000 mark for the first time, he said.

“The headlines encouraged a wave of new and inexperienced buyers who chased the same returns at the same time.”

“It was a huge percentage gain. GDX jumped 183% from the March bottom to the top in August in less than five months,” he said.

“It was a smart thing to buy it in March. Now it’s a little bit late in the game.”

Caveat emptor

Kaplan emphasized that the market is too exuberant at the moment.

“It has reached a point where bullishness is at a maximum,” he said about the U.S. equity market in general.

“People are still putting money in this fund. They bought at the highest point and they’re not giving up.

“That’s one of the most dangerous times to buy.”

Investors tend to get overly confident when they hold winning bets, he explained. When they are beginning to lose money at the beginning of a downtrend, they avoid closing their positions for fear of taking losses, even small losses, he added. If the position has been profitable, investors hesitate to sell for fear of missing out on further upside.

When there is a market meltdown, he said, “asset prices can drop brutally,” he said.

That’s when investors sell and panic, with the selling soon spiraling out of control.

“It’s only when investors capitulate that can you see the bottom,” he said.

One bearish sign was the substantial net fund inflows into the gold miners ETF.

“Two weeks in a row, GDX has experienced one of the biggest inflows...around Thanksgiving and during the first week of December,” he said.

“People are still piling in.”

14-month horizon

But buying the notes is not as reckless as buying the fund, he said.

“It actually makes sense in the course of 14 months, simply because it could be higher a year from now,” he said.

Kaplan said he expects the ETF to retreat sometimes this winter.

“It may bottom two or three months from now, perhaps,” he said.

The sell-off is not going to last very long, he predicted, given that the ETF has already been in a downtrend since August.

“Once it bottoms, it will go up again.”

“In 14 months, GDX will have plenty of time to come back,” he said.

Leverage

The 3x leverage on the upside was the main advantage of the structure.

“If the fund drops a lot, then recovers, its return at maturity might be modest. The advantage of the three-to-one is that even if the return is modest, it will magnify your gain,” he said.

Another advantage, which is associated with all structured notes, is that the structure may force investors to refrain from selling at a loss.

“For some people, having their money locked in might work better. If the fund drops 20%, they’ll have to sit tight.

“That might be good for people who tend to be too emotional, who don’t have the discipline, or the stomach to watch their portfolio go down.

“It gives you an opportunity to hang in there for the entire 14 months.”

But the notes, despite the leverage would not be a shrewd pick for a really bullish investor.

A miss for bulls

“I think you have a good chance of getting much more than 30% over 14 months,” he said.

In fact, investors may get more even sooner.

“Just look at the returns from March to August. It nearly tripled!”

The volatility of the miners ETF places the risk mostly on the upside for Kaplan.

It’s not out of the ordinary for this fund to double. Aside from this year’s bull market, the fund from January to July 2016 rose 150% for instance.

Over longer periods of time, for example during the three years that followed the start of the financial crisis, the ETF jumped 285%.

“If it’s up, let’s say 100% and you’re capped at 30%, it’s a substantial opportunity cost,” he said.

“Of course, no one forces you to buy this note if you’re bullish. You can always be long the ETF itself.”

But for investors seeking three-to-one exposure, the note is superior to an equivalent leveraged ETF because the leverage only applies to the upside.

“Yes, you have an advantage with the one-to-one downside over any leveraged ETF. But anything is better than any leveraged ETF. Leveraged ETFs should not exist,” he said.

He was referring to the decay or “slippage” associated with positions held in leveraged ETFs, which can turn negative even if the underlying is not as a result of the daily reset of the leverage.

“More to the point: the question is how likely are you to benefit from this three times exposure given the cap?”

The answer lies in investors’ return expectations.

“The leverage is going to help you only if GDX is up 10% during the period. The chances of a 10% return in 14 months are very, very small in my view,” he said.

“So, it’s likely that the leverage is not going to help you.

“In fact, if the fund is up 100% or 200%, it’s going to work badly against you.”

Bearish overall

“The only scenario where it might work for you is if the fund trades sideways. Then you can do very well.”

But that’s not what Kaplan has in mind.

“I see GDX dropping 20% to 25%. But I expect a strong rebound after that, a rise of 100% to 200%,” he said.

Kaplan said short term, his general market outlook is bearish as he sees too much exuberance, complacency and crowded trades in the market.

“A lot of assets are going to drop, not just GDX. Nasdaq has recorded huge records of buying. November was the biggest month of ETF inflows in history.

“A lot of people are taking money out of the bank, piling into the market pretty much everywhere.

“We haven’t seen such a divergence between the most experienced investors, who are currently heavily selling, and the least experienced ones, who are buying frenetically in a very, very long time.

“It’s not a good thing.”

BofA Securities, Inc. is the underwriter.

The notes will price in December.

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