UBS ETRACS Monthly Pay 2xLeveraged Mortgage REIT ETN (NYSEARCA:MORL) is thought to be a "too good to be true" investment, with extremely high dividend yield. Should you avoid MORL even if it can provide you with a stellar yield? At 20% dividend yield, if the stock price stays the same, it takes only three and a half years to recover all of the initial investment. It is indeed a temptation.
In this article, we will look at the performance of MORL since its inception from 2012/10/17 to 2014/7/17 as compared to its top six components. During this period, the 10-Year Treasury yield has a change of 140 basis points from high to low, which has severe impact on mREITs, including MORL.
Performance of MORL and its components
The top six components of MORL: Annaly Capital Management (NYSE:NLY), American Capital Agency Corp. (NASDAQ:AGNC), Chimera Investment Corp. (NYSE:CIM), NorthStar Realty Finance Corp. (NYSE:NRF), Starwood Property Trust (NYSE:STWD) and Two Harbors Investment (NYSE:TWO) occupy more than 50% of MORL. Therefore, we can take a meaningful comparison of the performance of MORL vs. its largest components. In this study, we assume that the dividends are reinvested.
First, let us compare MORL to NLY, which is the largest component. The chart below shows that during this period, MORL has a return of 23.1% vs. a loss of -13.8% for NLY.
The result may come as a surprise to many. MORL investment is approaching to its previous high in April 2013, but NLY is still in the negative territory and has a long way to go just to breakeven. In fact, NLY rose slower than MORL during the upturn, but dropped as fast as MORL during the downturn. If you leverage NLY by 2x, you would have a -27.6% return.
Next, we compare MORL to its second-largest component - AGNC. The chart below again shows that AGNC has a negative return of -5.91% vs. a positive return of 23.1% of MORL. Again, AGNC is inferior to MORL.
If we compare these three investments by high and low during this period, MORL has slightly larger high/low ratio, nowhere near doubled. In fact, both NLY and AGNC lost more money at lows than MORL.
(Data taken from charts in this article)
The reason for this superior return-to-risk performance of MORL is clearly its diversification. The components in MORL have very different business models, although they are all in the REIT business.
Not all mREIT companies have the same interest rate exposure. For example, Two Harbors Investment Corp. weathered the rising of interest rates in 2013 much better than NLY and AGNC. TWO has a very decent 18.05% return, as compared to MORL's 23.10%, in spite of not having the kind of leverage as MORL. TWO is the fourth-largest component of MORL.
(Data taken from charts in this article)
The third-largest component of MORL is Starwood Property Trust. STWD originates, acquires, finances, and manages commercial mortgage loans and debt investments, as well as commercial mortgage-backed securities. It has a much diversified portfolio: hospitality, office, retail stores, residential, multi-family, and others. Its business is less sensitive to the interest rate fluctuation.
It showed an impressive return of 46.56% during the same period. It suffered very little impact of the rising interest rates in 2013.
MORL's fifth-largest component is Chimera Investment Corp. CIM returned 58.2% vs. 23.1% of MORL during the same period. CIM invests in residential mortgage-backed securities, residential and commercial mortgage loans, real estate-related securities and other asset classes. It was only slightly impacted by the rise of interest rate in 2013.
Lastly, we look at MORL's sixth-largest component: NorthStar Realty Finance Corp. During the same period, NRF posted a return of stellar 201.37%. NRF operates as a commercial real estate (CRE) investment and asset management company. It originates and acquires loans secured by commercial, multi-family, and healthcare properties. It also has diversified lease properties, including office, industrial, and retail properties leased to corporate tenants, healthcare operators, and industry. Its asset management business focuses on commercial real estate-related activities. As a result, we can see that unlike the pure mREIT players, it did not suffer at all from the Treasury yield rise during Q2 to Q4 of 2013.
One thing should be noted that the composition of MORL changes monthly. Therefore, the impact to the MORL performance cannot be directly calculated using the current composition.
Having components like NRF and STWD in MORL's portfolio really helps to neutralize the impact of rising interest rate in 2013.
It is true that MORL consists of high-volatility securities in its portfolio amplified by leverage, but its volatility risk is partially compensated by its diversification. Let us do a return-to-risk analysis according to the methodology described in my earlier article. Here, I used the monthly return to determine the standard deviation (standard deviation of the monthly change in adjusted prices), and took the annualized return from the above charts as return. All numbers are from the same period: 2012/10/1 to 2014/7/1. The result is shown in the table below.
(Source: Standard deviations calculated Yahoo Finance stock prices, and annualized return taken from the charts.)
We can see that MORL does not have 2x of the standard deviation of its components. Its diversification really dampens a lot of the risk. On the other hand, its annualized return is better than three of its six largest components.
Of course, if we could tell the future, we would have invested in NRF and STWD instead of MORL. But we can't.
Other advantage of ETN
Advantage of ETN is that there is no tracking error. When an investor buys an ETN, the underwriting bank promises to pay the amount reflected in the index, minus fees upon maturity. As such, ETNs are treated as prepaid contracts, it eliminates any tracking errors. An investor who owns a note is promised a contracted rate of return by the issuing bank. When an investor purchases an ETF, he is purchasing an asset like a stock or index.
Control your risk
There are two risks to consider: volatility risk and credit risk.
The amount of volatility risk is really dependent on your investment amount. A way to control the risk is to use a portfolio position sizing methodology. For example, if you can afford to lose, say, $1,000, your maximum investment should be $1,000/ volatility. And this $1,000 should not be more than 2% of your total account value, which is $50,000 in this example.
In the table below, I list the maximum allowed investment for every $1,000 for each of these investment. According to this position sizing rule, you should not invest more than $11,258 in MORL for your account of each $50,000.
With such high dividend, MORL investment is likely to grow faster than your overall portfolio. If you are disciplined, you will cap your investment of MORL by your position-sizing and take out any excess amount from MORL investment from time to time. Doing so can safely provide you with good return with acceptable risk.
In addition to the volatility risk, credit risk is an inherent part of the ETN investment risk. Since MORL is an ETN, we should consider the ETN risk.
ETNs are issued by a major bank as senior debt notes. ETN differs from an ETF, which consists of an actual security. Since ETNs are unsecured, unsubordinated debts, their risks are the same as that of bonds of similar priority in the company's capital structure.
In September 2008, at the time of its bankruptcy, Lehman Brothers had issued three ETNs, and investors who owned shares of these ETNs at the time lost a substantial part, if not all, of their investments; the risk is real.
If ETNs are backed by a bank with a high credit rating, they are pretty secure products. Their credit risk is actually lower than those of ETFs. The issuer of MORL is UBS, one of the largest banks in the world and the largest private banker in the world, with $1.7 trillion in assets.
Of course, there is no way to guarantee anything in the investment world. However, if UBS defaults on its senior debt, you can be sure that most of your other investments in the stock market will have tanked as well. So, you need to handle this kind of risk differently, for example, buying properties, investing in art, keeping the money in your bank accounts, etc. It is not something specific to MORL. It is just the risk of financial investment in general.
MORL is an attractive investment if you know where the risk lies. If you are into dividend investment and have done research on MORL and are not sure about its risk, you should not automatically discard it just because it is 2x leveraged and it is an ETN by a foreign bank. After all, USB belongs to the "too-big-to-fail" category of banks. UBS should give you some comfort that it will not go away anytime soon. If you want to find more about what happened to UBS during the financial crisis of 2008, you can read this report.
To manage the volatility risk, you should limit your investment by using position-sizing. This is required for any investment, not just MORL.
Disclosure: The author is long MORL, NLY. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.