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Summary

  • DVHL is a diversified income vehicle currently yielding 14%.
  • The ETN holds several asset classes that find their market prices in part on the basis of their tax-advantaged status for the U.S. investor.
  • The tax advantages of these portfolio components do not accrue to the investor because all distributions from an ETN are ordinary income.
  • By foregoing the tax advantages inherent in the component assets, the DVHL investor is overpaying for those assets.

I recently wrote an analysis (see here) of UBS ETRACS Monthly Pay 2xLeveraged Diversified High Income ETN (NYSEARCA:DVHL). The ETN is a broadly diversified portfolio comprising several income asset-classes put on hyper-drive with 2x leverage. The ETN is returning about 14% in distributions. On the surface that 14% can look appealing to the income investor desiring high yield and prepared to take on the leverage risk. I submit that with a closer look, even the least risk-averse yield-seeker would be wise to pass on this one.

Why? Well, my primary objection is the tax-status of the ETN compared to the tax-status of its components. I'm focusing here exclusively on the U.S. investor as I have limited understanding of tax consequences for international investors. But even there it should not matter, as I'll describe.

Consider that about 10% of the ETN is invested in municipal bond ETFs. Now, don't get me wrong here, I love munis; I'm invested in munis; I think munis are going to have a great year. But I - and, I'll submit, essentially every other municipal bond investor - invest in them largely for their tax-exempt dividends. I've written about muni-bond closed-end-funds several times and included tables translating the returns to taxable equivalents for various U.S. brackets (see here and here for examples). If you're in the higher tax brackets, there is a lot to like about muni bonds; but if you're not, doesn't it only make sense to seek higher returns for the equivalent risk?

But municipal bonds are not the only one of DVHL's asset classes whose tax-status makes it an inappropriate component for an income ETN. Another 14% of the DVHL portfolio is in dividend stocks. Dividend stocks are, of course, a primary investment vehicle for the tax-conscious investor because qualified dividends are taxed at 15% for most taxpayers. But when those dividends are passed through an ETN, they are taxed as ordinary income.

So now we're up to a quarter of the portfolio for which the investor in DVHL is paying in excess of what the risk/return equilibrium should suggest is reasonable. Add another 10% in preferred stocks, most of which also pay qualified dividends, and we're well over a third of the portfolio.

In addition, there are tax advantages to holding MLPs having to do with deferral of taxes until the investment is sold. In DVHL, everything is ordinary income, taxable when it's paid. Yet another tax-efficiency strike against DVHL; and MLPs represent another 14% of DVHL.

For the record, I am certainly not an expert in tax matters, but I am sufficiently aware to realize that the market's perception (and subsequent pricing) of these asset classes includes their relative tax efficiencies. To pay for those efficiencies without reaping the benefits they confer, and increasing the risk potential with twofold leverage, seems beyond unwise in my view. And, albeit to a somewhat lesser extent perhaps, the same logic would apply to the international investor who is unconcerned regarding U.S. tax status: Why pay for tax-exempt income if you're not going to derive the benefit of such? I'd ask the international investor if he or she would consider investing in U.S. municipal bonds. If not, why consider adding them as a 10% drag on this product?

I've even seen it suggested that the tax status of this ETN doesn't matter because the investor holds it in an IRA. Again, it simply doesn't make sense. One consideration for an IRA should be its relative tax-advantaged (to the extent deferral is an advantage) status. It's a place to hold less, not more, tax-efficient investments. In any case, it's certainly no place for overpriced muni bond funds.

There are several good arguments for staying away from this ETN and its sibling high yielder, ETRACS Monthly Pay 2xLeveraged Closed End Fund ETN (NYSEARCA:CEFL), based on fundamental investment principles. Some counter those arguments and consider them reasonable high-yield vehicles (debated extensively here). In my view, both sides of that argument can have some merit, and an individual can decide between them based on personal priorities. But, to me there is no justification for buying into any investment that is priced with full consideration for a set of tax advantages and foregoing those tax advantages completely. It's just common sense.

Source: Why The UBS-ETRACS 2X High-Income ETN Is A Poor Choice