Gold futures leveraged and inverse products

Gold futures leveraged and inverse products (L&I products) are traded on the Hong Kong Exchanges and Clearing Limited (HKEX), presenting an alternative to gold investment products and is designed for sophisticated trading-oriented investors.

Investors may confuse gold futures L&I products with conventional gold exchange traded funds (ETFs). The two investment products vary greatly indeed. While gold ETFs primarily invest in gold bullion with an aim to track the price of gold, gold futures L&I products invest in gold futures and/or swaps with an aim to deliver a daily return equivalent to a multiple (capped at leverage factor of 2 times (2x) or inverse factor of 2 times (-2x)) of a specified gold futures index (i.e. the underlying index) return.

Like other L&I products traded on HKEX, a gold futures leveraged or inverse product has a rather complex structure and risk exposure. You should know how it works and the risks involved before making an investment decision. The following pointers can help you understand more about this product.

Knowledge of leveraged and inverse products and futures-based ETFs should help one to understand more about gold futures L&I products.

A gold futures leveraged or inverse product aims to seek leveraged (capped at 2 times (2x)) or inverse (capped at 2 times (-2x)) investment results relative to an underlying gold futures index on a daily basis. To achieve this investment objective, it will invest in gold futures contracts normally subject to a predefined rolling schedule to obtain the required exposure to the gold futures index and/or swaps. In the case of using swaps, the swap counterparty will be provided a fee to deliver to the gold futures L&I products the corresponding leveraged or inverse exposure to the gold futures index and depending on the particular swap arrangement, may be provided with a portion of the net proceeds from subscription of units in the L&I product. Under exceptional circumstances, some managers may use their discretion to deviate from the predefined rolling schedule in the interests of investors. For details, please refer to the section “Risk of rolling futures contracts” below.

Different gold futures contracts are traded on various exchanges, such as New York Commodity Exchange (“COMEX”) (operated by Commodities Exchange, Inc., a subsidiary of New York Mercantile Exchange, Inc.), Shanghai Gold Exchange, and the Tokyo Commodity Exchange, among which COMEX Gold Futures contracts is one of the most liquid gold futures contracts.

While the product offers investors an opportunity to profit from the rising or falling gold price, they should note that the performance of the underlying gold futures index and the gold futures L&I products can significantly deviate from the spot price of gold. This is because the underlying index is based on the price of gold futures contracts and not on the price of physical gold. The price movement of gold futures contracts may not always go in line with that of gold in the spot markets. Accordingly, the gold futures L&I products may underperform a similar investment that is linked to the spot price of gold.

A variety of factors can lead to a disparity between the expected future price of gold and the spot price at a given point in time, such as the cost of storing the gold for the term of the futures contract, interest charges incurred to finance the purchase of the gold and expectations concerning supply and demand for the gold.

For illustrative purpose, the chart shows the spread between gold spot price and the COMEX Gold Futures contracts (front-month) since 2015. During the period, the spread has been typically within US$ 20 per troy ounce; but increased significantly to nearly US$ 150 per troy ounce during market volatility. You may also utilize the performance simulation tool on the gold futures L&I products’ website to help yourself understand the above mentioned difference.

Before making an investment decision, it is important to understand the key risks of L&I products such as the following: investment risk, volatility risk, long-term holding risk, risk of rebalancing activities, liquidity risk, intraday investment risk, portfolio turnover risk, correlation risk, futures contracts risks, rolling of futures contracts risks, risk of mandatory measures imposed by relevant parties, trading time differences risk (for futures-based L&I products which invest in futures traded on an overseas futures exchange), termination risk, leverage risk and unconventional return pattern.

Investors may refer to our web articles, “Leveraged and inverse products – Benefits and risks” for details.

In particular, there are several additional key risks involved in gold futures L&I products. Investors’ attention should be paid to the below risks.

The product does not invest in the physical gold. The underlying index comprising specific gold futures contracts consists of only gold futures whose price movements may deviate significantly from the gold spot price. The product does not seek to deliver a leveraged or inverse return of gold spot price.

Gold prices may be highly volatile and may be affected by numerous events or factors. There is no guarantee that the gold price, and the prices of gold futures will move in favor of a particular gold futures leveraged or inverse product.

Similar to investing in other L&I products and gold ETFs traded on HKEX, investors should gain full understanding of the features and risks of gold futures L&I products from primary sources such as product key facts statement and the offering document before making an investment decision.

Similar to futures-based ETFs, gold futures L&I products need to rollover futures contracts to achieve its investment objective.

“Rollover” refers to selling or covering existing expiring futures positions and replacing them with the same futures positions (i.e. either long or short positions) with a later expiration (i.e. longer-term contracts). If the prices of the longer-term contracts are higher (or lower, in the case of inverse products) than those of the expiring contracts, a loss may incur over time (i.e. a negative roll yield) due to such pricing difference and would adversely affect the net asset value (NAV) of the product.

You should note that save for the transaction cost incurred, a “rollover” in itself is not a loss or return-generating event. That is, the NAV of the gold futures leveraged or inverse product will not suffer an immediate loss or enjoy an immediate gain due to “rollover”.

Contango risk relating to gold futures leveraged product
If the futures market is in contango (i.e. the price of near-term contracts is lower than the price of longer-term contracts), a negative roll yield may be realized over time and reflected in the NAV of the gold futures leveraged product when the gold futures leveraged product repeatedly buys the longer-term contracts at a price higher than the selling price of the near-term contracts, and the price of the futures contracts moves down over time to converge to the spot price. Please refer to the article “Crude oil futures ETF” for more information on the associated risk.

Backwardation risk relating to gold futures inverse product
Similarly, a gold futures inverse product rollovers futures contracts to achieve its investment objective by covering the current short positions in existing expiring future contracts and shorting the longer-term futures contracts.

If the futures market is in backwardation (i.e. the price of near-term contracts is higher than the price of longer-term contracts), a negative roll yield may be realized over time and reflected in the NAV of the gold futures inverse product when the gold futures inverse product repeatedly covers the short positions in the near-term contracts at a price higher than the price of the longer-term contracts. As such, the NAV of the gold futures inverse product may be adversely affected.

Investors should be aware that negative roll yield of L&I products is likely to be larger than the negative roll yield experienced by a comparable futures-based ETFs because of the leveraged effect of the L&I products.

If the price of the futures contracts included in the gold futures L&I products’ portfolio hit certain price limits, depending on the time of the day and the limit being reached, the trading of the futures contracts may be limited within the set price limits, suspended for a short period of time, or suspended for the remainder of the trading day. This may affect the gold futures L&I products’ tracking of the leveraged or inverse of the daily performance of the index, and if a trading halt takes place near the end of a trading day, may result in limitations in daily rebalancing.

Under exceptional market circumstances, the price of gold futures contracts may drop to zero or a negative value in a short period of time. In this case, you could suffer a total loss of your investment in the gold futures leveraged product.

The gold futures L&I products have risk exposures concentrated in the gold futures market and are subject to the price volatility of a single asset only (i.e. gold). Such volatility may be extremely high and substantially higher than the volatility experienced by equity indices or a commodity index which is made up of multiple types of commodities. If a gold futures leveraged or inverse product holds only a single futures contract (e.g. the product holds only the near-month futures contract), this may result in large concentration risk and the price volatility of the product may be higher than that of a product which holds futures contracts with different expiry months.

Investors should also refer to our web article, “Futures-based ETF” to understand the risks involved for investing in futures-based product such as risk of statutory restrictions on number of futures contracts being held. Where the manager may adopt a swap-based synthetic replication strategy, investors should also pay particular attention to the below risks.

The gold futures L&I products may suffer significant losses if the counterparty fails to perform its obligations under the swaps. The value of the collateral assets may be affected by market events and may diverge substantially from the performance of the gold futures index, which may cause the gold futures L&I products’ exposure to the swap counterparty to be under-collateralised and therefore subject to credit risk and potentially significant losses.

The gold futures L&I products may bear the swap fees, which are subject to the discussion and consensus between the gold futures L&I products and the swap counterparty based on the actual market circumstances. In extreme market conditions and exceptional circumstances, the swap counterparty’s costs of financing for the underlying hedge may increase significantly and in return increase the swap fees.