DGL Is Likely To Rally In The Coming Year

ETFS

As you can see in the following chart, the Invesco DB Gold Fund (NYSEARCA:DGL) has performed quite strongly this year with shares sitting on a 24% year-to-date gain.

It is my belief that now is a solid time to buy gold. I believe that the long-run fundamentals suggest that gold is going to head higher over the next year and I believe DGL will be a good instrument to play the rally. However, as a caveat, I do believe that investors need to be aware of DGL’s roll yield issues and its associated strategies for mitigation.

Gold Markets

To start this piece off, let’s take a look at where gold is currently trading and what patterns are at work in the market.

From a technical perspective, gold is in the midst of a prolonged and fairly deep pullback with price at one point dropping nearly 11% from the peak. However, based on the fact that gold found support earlier this week and that momentum is shifting to the upside as seen by the MACD nearing positive territory, I believe that the short-term technical picture is bullish at this point.

When we discuss technical analysis, I believe it is important to frame the view inside of the fundamental picture. In my opinion, this approach helps us focus on what is most important (the key drivers of the price of gold) and use technical analysis as a supplemental tool for entering and exiting trades around an established fundamental theme.

In the case of gold, one of the key fundamentals investors need to be aware of is its momentum tendencies. That is, when investors park capital in gold, it tends to prop up the price. And when the price of gold is propped up, it actually attracts momentum-chasing investors in a somewhat virtuous cycle. For example, here is a chart that shows the average one-year performance of gold following a certain level of performance over the past year.

There is a clear and unmistakable trend at work in the data which shows that gold tends to perform strongly in the future after it has performed strongly in the past. In other words, given that gold has increased by around 25% over the past year, the last 50 years of data would suggest that we can expect an average one-year return in gold of around 19%. This certainly is an excellent relationship suggesting higher prices for DGL holders; however, we must remember that this is an average and historically there were some data points above and below this figure.

Gold also attracts trend-following traders. That is, when gold hits new highs or lows in its existing trend, this action tends to trigger further returns in the same direction.

This chart is a bit complicated, but it shows the average return in gold a certain number of months into the future after gold has hit a fresh six-month high in its trend. Gold hit a fresh six-month high in August. This data would suggest that from August going forward, on average, gold investors can expect a return of around 20% over the next year. Again, note that this is an average return of 50 years of data and the actual is likely not going to be exactly at this data point.

An additional consideration for trading gold at this time is the dollar. Most traders are aware of the clear correlation between a decline in the dollar and a rally in gold.

However, there is also a predictive relationship associated with past changes in the dollar. That is, when the dollar has moved a certain amount in a given year, it tends to lead to gold rallying or falling.

At the time of writing, the trade-weighted dollar index is showing a year-over-year drop of around 2-3%. Historically speaking, when the dollar falls by this amount, not only does gold rally during the drop, but it also suggests further rallies in gold, with an average rally of 11% seen in the 12 months following such a change.

An additional bullish fundamental to key in on at this time is the relationship between the VIX and gold. At the time of writing, the alarming news of the president of the United States contracting the virus has resulted in a leap in the VIX with the index nearing 30 (with it breaching 30 a few times over the past two weeks). Historically speaking, a VIX in this range is associated with a rally in gold over the next year.

As you can see, when the VIX reaches this territory, we tend to see gold rally by 14% over the next year. I believe this is a very important relationship to grasp because this shows that investors actually do use gold as a safe-haven asset: when markets are turbulent (as evidenced by a rising VIX), investors tend to park capital into assets like gold which leads to outsized returns over the next year.

Put simply, I believe the fundamentals and their associated statistics are firmly bullish for gold at this point. However, we must address DGL’s instrument-specific methodology prior to ending this piece.

About DGL

In the gold ETP space, there’s a fairly wide variety of products offered to investors and traders. While this diversity gives investors a plethora of options for approaching the market, it can make for a headache in trying to understand what any specific strategy or methodology does.

In the case of DGL, it is following a fairly complex methodology of holding and rolling gold futures contracts. The purpose of its actions is to minimize roll yield. DGL utilizes the DBIQ rolling methodology (similar to many of Invesco’s commodity ETPs).

If you’ve read my articles for some time, then you’re likely aware that I’m actually a pretty big fan of DBIQ. If you’re unfamiliar with it, DBIQ is a roll-yield-minimizing family of strategies created by Deutsche Bank. The basic DBIQ approach in the most popular ETPs is to maximize the benefits or minimize the detriments of roll yield for a long trader in an ETF or ETN.

So what is roll yield and why does this matter? Good question. Roll yield is what you get when you hold a futures contract which is priced above or below the spot commodity. Over time, futures converge to spot which means that if your futures were above or below the spot price of the commodity, you would have either made or lost money from the convergence.

The good news is that DBIQ’s methodology is designed around maximizing benefits to long traders in the ETP. This means that it’s trying to minimize roll losses when the market is in contango (futures above spot) and maximize benefits when the market is in backwardation (spot above futures).

The bad news is that gold futures curves are typically in a reliable degree of contango based on the borrowing cost of capital. What I mean by this is that if you were to look at the futures curve and calculate the difference to spot at each point of the curve, you’ll find a very clear and consistent relationship where the futures curve is generally increasing at around the borrowing cost available to traders over that time frame (give or take a few basis points). This means that in the current market dynamic, there is little benefit to dynamically shifting exposure – the futures curve will generally be equal to the borrowing cost at that time frame and the annualized roll yield losses will likely just be this interest rate.

Does this relative ineffectiveness of DBIQ in the gold markets make DGL a poor investment? No. The overall returns of this ETP are still going to be heavily driven by the outright changes in gold. However, investors should be able to look through the marketing and see that its sleek methodology really isn’t that effective in a futures curve as clearly priced as gold. This said, investors should expect to lose about 2% per year to roll yield at this point which means that the return you make in DGL over the next year will basically be the change in the price of gold minus 2% minus the expense ratio.

Conclusion

Gold is technically in a pullback, which is likely to resolve in further upside to the trend. Gold is fundamentally supported at these levels based on changes in the dollar, market volatility, and investing momentum. DGL uses a very strong rolling methodology for tracking gold; however, the benefits to investors are questionable.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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