UBS Leveraged ETNs: Separating Fact From Fiction



There have been wildly inaccurate assertions regarding leveraged ETNs such as CEFL and MORL.

There is a possibility an investor might think that because some false risk factors can be refuted that there are not real risks associated with a leveraged ETN.

The redemption feature for these securities de facto eliminates the credit and basis risk. There are no real economic risks associated with the call features.

The emergence of leveraged ETNs such as UBS ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN (NYSEARCA:CEFL) and UBS ETRACS Monthly Pay 2xLeveraged Mortgage REIT ETN (NYSEARCA:MORL) have sparked considerable investor interest. This is mostly due to their high yields as reported recently in '18% Yielding CEFL Trading At A Discount To Effective Intrinsic Value' and 'MORL Yielding 21.8% After April Dividend Increase.'

The high yields and the ETN structure have also generated considerable skepticism and criticism. The criticism has ranged from the simplistic "if it sounds too good to be true" to wildly inaccurate assertions such as: "the most significant risk of owning ETNs is the fact that you are betting solely on the credit worthiness of the issuer--in the case of CEFL, this is UBS." That appeared in comments to my article '17.8%-Yielding CEFL - Diversification On Top Of Diversification, Or Fees On Top Of Fees?' and that the ETNs are based on undisclosed secret models the retail investor has no way of modeling to determine the real value of the security and that "if UBS provided the model on its website to value this it would be trading significantly lower than where it trades currently." which was asserted by a commenter Alex H to an informative Seeking Alpha article by contributor Left Banker 'Is It Safe? II: Leveraged ETN Yielding 18%'.

The problem with the wildly inaccurate assertions is not just that some investors who would absolutely do better by investing in a leveraged ETN as opposed to buying the underlying securities on margin themselves, would not do so. By doing better I mean having the exact same risk and return profile for all economic purposes but possibly having lower transaction and borrowing costs.

A more insidious danger that results from the wildly inaccurate assertions is that an investor who determines that some of more easily refutable assertions are false might then disregard all of the actual real risk factors.

An example of an easily refutable completely false assertion is that: there is an economic value to the call features of a leveraged ETN that imparts value to the issuer, thus reducing the true value of the security. Unlike a leveraged ETN, such a reduction in value really is the case with a callable bond. The fact that ETNs like CEFL and MORL always trade near their net asset or indicative value should allow most people to dismiss the assertion that call features reduce the true value as nonsense. Furthermore, one does not have to be much of an expert to understand that the "option" to buy back any security with a strike price that is always equal to the fair value of the security can never have any economic value. No one would pay anything for an option to buy a stock for exactly whatever the price it is on the NYSE at the time the option is to be exercised.

The main real risk with a leveraged ETN relative to a non-leveraged instrument with the same portfolio comes from the leverage. As I explained in the article '30% Yielding MORL, MORT And The mREITs: A Real World Application And Test Of Modern Portfolio Theory,' 2X leverage doubles the volatility. The risk as measured by the standard deviation of MORL is twice that of Market Vectors Mortgage REIT ETF (NYSEARCA:MORT), which has the same portfolio of mREITs without the leverage. Furthermore, many of the mREIT components of MORL are themselves leveraged, sometime as much as 8X. Many of the closed-end funds that comprise CEFL also employ some leverage, although not as much as the mREITs.

The best way to separate the facts from the fiction regarding MORL and CEFL is to understand why they are structured the way they are. Some have claimed that ETNs like CEFL and MORL were structured in such a way to preclude investors from being able to determine their fair value. The informative Seeking Alpha article by contributor Left Banker 'Is It Safe? II: Leveraged ETN Yielding 18%' attracted numerous comments critical of CEFL including Alex H who incorrectly said about UBS, the sponsor of CEFL and MORL: "When they arrive at the pricing the model that says the security should be paying 25%. What do they do? They sell it to you at 18% pocketing the 7% difference + the fees." Some have misleadingly asserted that the 50,000 minimum for share redemption was included so as to nefariously deprive small investors of the benefits of the redemption feature. That might possibly make sense if one did not know why UBS has that 50,000 share minimum. Although, arguing that the mitigation that the redemption feature imparts to basis and counter-party risk does not accrue to the benefit of small investors, makes no sense on any level.

Understanding the reasons for the various aspects and features of MORL and CEFL are the keys to refuting the false assertions. With regard to the 50,000 minimum for share redemption, UBS would love to collect the $62.50 from small shareholders redeeming 100 shares at a time. The reason for the 50,000 minimum for share redemption has to do with why MORL and CEFL are structured as notes rather than funds.

Basically, the ETN structure allows UBS to circumvent the limitations on leverage that the 1940 Investment Company Act imposes on mutual funds. If UBS allowed small investors to redeem shares, it might look too much like an open-end mutual fund. Likewise, I would be shocked if UBS does not essentially own all of the components of the ETNs in the correct proportion and simply pass-through the dividends, which thus eliminates the risk they would incur if they were bucketing the ETNs. They make their money by managing assets rather than taking risks. However, legally if the securities were owned by MORL and CEFL, they would be funds rather than notes.

A good way to understand MORL and CEFL is to realize that they are structured to emulate a no-load open-end mutual that could employ 2X leverage that have the exact same risk and return profile that would be achieved by an investor owning all of the underlying components in a margin account employing 2X leverage. All of the mandatory redemption, acceleration and call features in MORL and CEFL are there for the same reason a broker needs the ability to issue a margin call if the value of the securities in a margin account falls below a specific threshold and liquidate the account if the margin call is not met. MORL and CEFL and no-load open-end mutual funds cannot issue margin calls, thus they need the ability to force the redemption of the investor's account at market value if the value of the securities drops enough to possibly create a negative equity position.

Most no-load open-end mutual funds have provisions in their prospectuses that allow the fund to force shareholders to redeem their shares at any time the fund's board deems it necessary. The analogy of a no-load open-end mutual fund, albeit with 2X leverage, is particularly apt for CEFL and MORL, since for holders with 50,000 shares that is exactly what it is for all practical economic purposes, and for those with less than 50,000 shares the fact that large shareholders can redeem at net asset value makes it virtually de facto what it is.

A major error made by those who fail to understand the structure of MORL and CEFL is to think that the call features impart value to the issuer at the expense of the investor. In commenting on the previously mentioned informative Seeking Alpha article by contributor Left Banker, Alex H also erroneously said "you should begin with a basic understanding of the difference between a callable bond and a non-callable bond. They have embedded options in them which makes their yields different depending on a whole host of factors related to how that option is structured. The same exact reasoning applies to this ETN. If UBS has the option to call or redeem this ETN at will whenever they want, and you have no idea what the value of that option is." That statement is completely incorrect. The value of the call option is exactly zero.

CEFL is, for all economic purposes, a pass through security in which you double the amount of the closed-end fund's yields and arrive at 18% because the underlying pays 9% and its 2x levered. The only reason it is an ETN rather than an ETF and that it has call options, redemption features and other bells and whistles, is that the 1940 act limits leverage in ETFs. The call features etc. are just to protect UBS from being in a negative equity position if the underlying shares fall so fast that it cannot be rebalanced. They are the equivalent of a broker's ability to liquidate your account if you do not meet a margin call.

UBS's option to call or redeem an ETN at will whenever they want has no more economic value than the option of your broker to liquidate your account if you fail to meet a margin call or the ability of no-load open-end mutual fund's ability to require investors to redeem their shares at net asset value. There would never be an economic incentive for UBS to call the ETN other than to prevent negative equity. Unlike callable bonds, it is never in the interests of no-load open-end mutual funds to force redemption because of favorable movements in the value of the fund. Rather, just like UBS the only time it would ever make sense to force the redemption of the ETN at net asset value would be if the aggregate value was so small it did not make sense to administer it anymore.

The" risk" that you might be required to redeem your shares at the fair value at the time is not a true risk, in the way that there is a real risk that a callable bond could be called and thus transfer value from the investor to the issuer. This brings us to the other major canard associated with MORL and CEFL, that of counter-party or credit risk.

As disclosed prominently by UBS, MORL and CEFL are dependent on the ability of UBS to make the payments required. That does expose the investor to some degree of credit risk. However, it is very different and of much less magnitude than the type of credit risk one would face by buying a regular senior bond issued by UBS.

If you were to buy a bond from UBS and something drastic happens causing UBS to be downgraded, to say BBB, you would suffer an immediate loss since the credit risk of the downgraded bond would be reflected in the market price. However, the net asset value of UBS redeemable ETNs such as MORL and CEFL would not be affected, and because shares of the ETN can be redeemed at net asset value, the market price of the ETN would not be impacted either.

If giant meteors were to simultaneously destroy Zurich, London and New York overnight there might be an advantage to holding a UBS fund which was bankruptcy remote as compared to a note. However, under reasonably foreseeable circumstances the redemption feature eliminates the credit risk.

Even if the ability to redeem shares did not exist, the UBS credit risk with MORL and CEFL would be rather small. USB has a relatively high percentage of their revenue from fees for managing assets, which is a much more stable revenue base than making loans, underwriting or trading securities. UBS is the biggest bank in Switzerland, operating in more than 50 countries with about 63,500 employees globally, as of 2012. It is considered the world's largest manager of private wealth assets; with over CHF2.2 trillion in invested assets. According to the Scorpio Partnership Global Private Banking Benchmark 2013, UBS had assets under management of US$1,705.0 billion, representing a 9.7% increase versus 2012.

Almost any investment has some remote risks. Your brokerage account is only insured for $500,000 by the Securities Investor Protection Corp. which in turn might become insolvent if those meteors destroyed Zurich, London and New York overnight. Likewise all mutual funds have custodians and transfer agents that conceivably could blow up creating other types of risk.

Some of those who might concede that the redemption feature eliminates the basis and credit risk of MORL and CEFL nevertheless claim that the 50,000 minimum for share redemption negates that benefit for small investors. That is completely false. A small investor benefits from the fact that there are plenty of large investors who would arbitrage any discrepancy between the net asset value and the market price of MORL and CEFL. Thus, always allowing the small investor to sell at very close to net asset value. This can be verified by the fact that the market prices of MORL and CEFL have never deviated significantly from the net asset value. Furthermore, UBS does allow brokerage firms to aggregate the holdings of small investors to achieve the 50,000 share threshold. Retail brokers like Charles Schwab would certainly facilitate such transactions were they to become necessary, since the net result would be to put additional cash into the accounts of their customers which is the broker's favorite thing.

MORL and CEFL do have real risks, that they can be called by UBS at net asset value is not one of them. It might be inconvenient, but if you were to receive cash for your shares, you could always recreate the same risk/return profile by buying the underlying shares on margin. You would not necessarily have to buy all of the components, but rather buy ETFs based on the same indices as MORL and CEFL. Those are MORT and YieldShares High Income ETF (NYSEARCA:YYY) for CEFL.

There are a few wrinkles that differentiate ETFs from ETNs. Regulators are generally not thrilled with clever bankers circumventing the limitations on leverage that the 1940 Investment Company Act imposes on mutual funds. For MORL this applies double as the Securities Exchange Commission has already asked for comments on this issue of whether mREITs should be allowed to use leverage far in excess of what mutual funds are allowed. On one hand this means that there is some possibility that leveraged ETNs and mREITs might not be allowed at some point in the future. That might mean that investors would be redeemed at then current net asset value whether they wanted to do so or not. However, conversely it could mean that future leveraged ETNs and mREITs are not allowed, but that existing ones are grandfathered. This, could allow them to trade at premiums.

I think the chance of any restrictions on leveraged ETNs and mREITs is slight. Especially for mREITs. The power of the real estate lobby is immense. It is not complete hyperbole to say that the US tax code is a mechanism for subsidizing and promoting real estate, that has a secondary purpose of raising money to operate the government.

Disclosure: I am long MORL, CEFL. 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.