17.8%-Yielding CEFL - Diversification On Top Of Diversification, Or Fees On Top Of Fees?

Mar.28.14 | About: UBS ETRACS (CEFL)

Summary

UBS ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN has a 17.8% yield on a monthly compounded basis.

Since each of the 30 closed-end funds in CEFL are themselves diversified, this is diversification on top of diversification.

CEFL on balance would seem to be a top holding for someone seeking high yields and willing to accept the higher volatility that 2X leverage entails.

This may be especially true for those now getting the higher returns from mREITs who want to diversify some of their interest rate exposure and still obtain high yields.

UBS ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN (NYSEARCA:CEFL) is not a closed-end fund but rather an exchange-traded note. The 30 components that make up the index upon which CEFL is based are closed-end funds. This provides a tremendous amount of diversification. The only thing that the 30 closed-end funds have in common is relatively high distribution rates. As the table below indicates, 20 of the 30 closed-end funds pay monthly and the rest pay quarterly, with 9 of the 10 quarterly 30 closed-end funds having ex-dividend date in March.

The exchange-traded note structure allows for greater leverage than a fund can employ which now results in a 17.8% yield on a monthly compounded basis, based on CEFL's first three months of operation.

Since each of the 30 closed-end funds are themselves diversified, this is diversification on top of diversification. There are close to a thousand individual securities among the 30 components that make up the index upon which CEFL is based. There may be some duplicates, but that is still a tremendous amount of diversification. The individual closed-end funds vary greatly in terms of their portfolios. PIMCO High Income Fund (NYSE:PHK) consists primarily of bonds with many of its largest positions now municipal bonds. Gabelli Equity Trust (NYSE:GAB) contains primarily common stocks. The largest component by weight of CEFL is GAMCO Global Gold, Natural Resources & Income Trust (NYSEMKT:GGN) that earns income through an option strategy of writing (selling) covered call options on gold and natural resources equity securities in its portfolio.

As I explained in the article 30% Yielding MORL, MORT And The mREITs: A Real World Application And Test Of Modern Portfolio Theory, a security or a portfolio of securities is more efficient than another asset if it has a higher expected return than the other asset but no more risk, or has the same expected return but less risk.

Portfolios of assets will generally be more efficient than individual assets. Compare investing all of your money in one security that had an expected return of 10% with some level of risk, to a portfolio comprised of 20 securities each with an expected return of 10% with same level of risk as the single security. The portfolio would provide the exact same expected return of 10% but with less risk than the individual security. Thus, the portfolio is more efficient than any of the individual assets in the portfolio.

On balance, CEFL's components seek higher returns either with common stocks that pay relatively high dividends, writing covered calls on common stocks and/or holding higher-yielding bonds. All of these have some equity risk component in them. While high-yield bonds are affected by interest rates, they are also affected by credit risk, which abates as economic activity increases which generally is associated with better stock markets.

Not surprisingly, for the period since its inception 70% of the variation in daily returns for CEFL can be explained by the daily variation in the S&P index. This is computed by a regression analysis using the daily returns of CEFL as a function of the daily returns on SPDR S&P 500 (NYSEARCA:SPY).

In contrast, only 5% of the variation in daily returns for ETRACS Monthly Pay 2xLeveraged Mortgage REIT ETN (NYSEARCA:MORL) can be explained by the daily variation in the S&P index. Since CEFL yields almost as much as MORL, this suggests that a portfolio consisting of both MORL and CEFL would have almost as much yield as a portfolio with just MORL but considerably less risk. A regression analysis using the daily returns of CEFL as a function of the daily returns on MORL shows that the correlation between the two is low, as only 21% of the variation of each is explained by the other.

CEFL with its diversification on top of diversification can be considered more diversified that MORL. While there are some differences in the mREITs that comprise the index that MORL is based upon, most are highly correlated with the mREIT index. The majority of the components of MORL are mREITs that borrow short term to buy agency securities. Thus, they are very sensitive to interest rates. A few exceptions include RAIT Financial Trust (NYSE:RAS) and Winthrop Realty Trust (NYSE:FUR) that have very low correlations to the mREIT index since a significant portion of their assets are actual real estate. Thus, the economic conditions that are associated with lower interests rates, such as high unemployment, which would be good for agency mREITs could be bad for those who own actual real estate and vice versa.

As for whether an investor should own an ETN such as MORL or CEFL as opposed to owning the individual components depends, among other factors, on how much leverage and risk the investor is willing to bear. However, there are certain circumstances where the answer is clear. Someone could duplicate the risk/return profiles of MORL or CEFL by owning all of the components in the same weight that they exist in MORL or CEFL and then using margin to achieve the same 2X leverage.

A retail investor with a margin balance of less than $10,000 at Fidelity would pay a margin rate of 8.575% while those with balances above $500,000 would pay 3.75%. Other major retail brokerage firms charge similar amounts. Even 3.75%. is above the 0.80% that UBS charges for the implicit borrowing and the 0.40% tracking fee for the exchange-traded notes. Thus, unless you can borrow at less than 1.20% , owning the ETNs is always more efficient do-it-yourself leverage.

Furthermore, do-it-yourself leverage could result in margin calls. Also, you generally cannot borrow on margin in IRAs and similar retirement accounts. On the other hand, a portfolio consisting on half MORL and half cash in a money market fund earning the current 0.01% would always be less efficient than a portfolio with 100% in an unlevered index fund such as Market Vectors Mortgage REIT ETF (NYSEARCA:MORT), which has the same components as MORL without any leverage. This is because you would be effectively borrowing at 0.80% and receiving 0.01% on your cash. Even if you could borrow at less than 1.2%, the transaction costs involved with having as much as 30 separate holdings rather than just one might tip the scales in favor of the ETN.

With CEFL, there is more of the question of fees on top of fees. Each of the 30 closed-end funds have fees, which would be on top of the CEFL fees. The mREITs in MORL have expenses also. However, in some cases CEFL owns closed-end funds that in turn own securities such as Annaly Capital (NYSE:NLY) and American Capital Agency Corp. (NASDAQ:AGNC), which are in MORL. Thus, with CEFL you could be paying three levels of expenses as compared to only two for MORL and only one if you took the do-it-yourself route by owning the mREITs yourself or even the shares of the stocks in the closed-end funds.

The fees may be somewhat offset when the components are selling for less than net asset value. That is the case for most of the 30 components as shown below. The striking exception being PHK with a price of $12.38 as compared to a net asset value of only $8.14. When the mREITs in MORL were selling at sharp discounts to net asset value this presented an opportunity as I indicated in: mREITs Trading At Steep Discounts To Book Value Violates Efficient Market Theory.

CEFL on balance would seem to be a top holding for someone seeking high yields and willing to accept the higher volatility that 2X leverage entails. This may be especially true for those now getting the higher returns from mREITs who want to diversify some of their interest rate exposure and still obtain high yields.

If someone thought that over the next five years credit conditions would remain relatively stable and thus CEFL would continue to yield 17.8% on a compounded basis, the return on a strategy of reinvesting all dividends would be enormous. An investment of $100,000 would be worth $226,399 in five years. More interestingly, for those investing for future income the income from the initial $100,000 would increase from the $17,800 initial annual rate to $40,299 annually.

3/26/2014

weight

price

distrib

ex

freq

NAV

GGN

GAMCO Global Gold, Natural Resources & Income Trust

4.70%

9.81

0.09

m

10.09

PHK

PIMCO High Income Fund

4.32%

12.38

0.122

m

8.14

IGD

ING Global Equity Dividend & Premium Opportunity Fund

4.27%

9.11

0.076

m

9.97

MIN

MFS® Intermediate Income Fund

4.23%

5.21

0.04

m

5.61

ETY

Eaton Vance Tax-Managed Diversified Equity Income Fund

4.22%

11.09

0.084

m

12.10

NFJ

AllianzGI NFJ Dividend Interest & Premium Strategy Fund

4.21%

18

0.45

13-Mar

q

18.28

ETV

Eaton Vance Tax-Managed Buy-Write Opportunities Fund

4.20%

14.17

0.11

m

14.57

GAB

Gabelli Equity Trust

4.19%

7.7

0.15

13-Mar

q

ETJ

Eaton Vance Risk-Managed Diversified Equity Income Fund

4.17%

11.3

0.09

m

12.45

BGY

BlackRock International Growth & Income Trust

4.17%

8

0.17

12-Mar

q

8.85

EXG

Eaton Vance Tax-Managed Global Diversified Equity Income Fund

4.17%

10.7

0.08

m

10.80

ETW

Eaton Vance Tax-Managed Global Buy-Write Opportunities Fund

4.14%

12.04

0.1

m

12.88

AOD

Alpine Total Dynamic Dividend Fund

4.13%

8.3

0.06

m

9.74

BOE

BlackRock Global Opportunities Equity Trust

4.10%

14.58

0.31

12-Feb

q

16.57

BCX

BlackRock Resources & Commodities Strategy Trust

4.10%

11.18

0.23

12-Mar

q

13.14

JGT

Nuveen Diversified Currency Opportunities Fund

3.89%

10.22

0.21

12-Mar

q

12.08

PTY

PIMCO Corporate and Income Opportunity Fund

3.76%

17.6

0.13

m

15.21

BIT

BlackRock Multi-Sector Income Trust

3.54%

17.47

0.12

m

19.75

BTZ

BlackRock Credit Allocation Income Trust

3.34%

13.53

0.08

m

15.26

FFC

Flaherty & Crumrine Preferred Securities Income Fund

3.10%

19.14

0.14

m

18.88

ESD

Western Asset Emerging Markets Debt Fund Inc.

2.98%

17.03

0.12

m

19.11

LDP

Cohen & Steers Limited Duration Preferred and Income Fund, Inc.

2.78%

23.66

0.16

m

26.14

EVV

Eaton Vance Limited Duration Income Fund

2.41%

15.41

0.1

m

16.56

JSN

Nuveen Equity Premium Opportunity Fund

2.16%

12.49

0.25

12-Mar

q

13.49

CII

BlackRock Enhanced Capital and Income Fund Inc.

1.97%

13.75

0.3

12-Mar

q

15.31

BCF

BlackRock Real Asset Equity Trust

1.76%

8.71

0.17

12-Mar

q

9.90

FAX

Aberdeen Asia-Pacific Income Fund Inc.

1.59%

6

0.04

m

6.62

BDJ

BlackRock Enhanced Equity Dividend Fund

1.31%

7.84

0.14

12-Mar

q

9.00

PFN

PIMCO Floating Rate Strategy Fund

1.15%

10.28

0.08

m

10.58

ERC

Wells Fargo Advantage Multi-Sector Income Fund

0.93%

14.52

0.1

m

16.19

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Disclosure: I am long CEFL, AGNC, MORL, RAS, CYS, ARR. 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.