With interest rates at rock-bottom levels and equity markets enduring severe fluctuations, low-volatility income streams are scarce. Consequently, investors have resorted to unconventional income investments to boost their yields, especially in the realm of exchange-traded products (ETPs).
Consider the popularity of UBS E-TRACS 2X Wells Fargo Business Development Company (BDCL), a leveraged exchange-traded note (ETN) that delivers twice the monthly performance of the Wells Fargo Business Development Company Index.
This index tracks a basket of 26 business development companies (BDCs), publicly traded private-equity firms that invest in or lend to start-ups or small companies. Investing in BDCs is a dicey proposition in the current economic environment, but UBS E-TRACS 2X Wells Fargo Business Development Company’s trading volume has surged since it launched in April. In fact, the ETN’s volume is seven times that of the unlevered UBS E-TRACS Wells Fargo Business Development Company (BDCS).
Although there’s an investment case for BDCs, these are speculative plays even before leverage enters the equation. In these fraught times, why would investors purchase levered shares of a fund that holds positions in companies with unpredictable earnings? The allure of a 20 percent yield is too difficult to resist.
The interest in high-yielding ETPs is understandable; these instruments generally offer broad diversification at a low cost. But like every investment, these ETPs entail risk. And these risks are magnified when a fund employs leverage.
A number of ETPs offer attractive yields with acceptable levels of risk–though investors should resign themselves to yields that are less than 20 percent.
SPDR S&P International Dividend (DWX) currently yields 7.4 percent, largely because of its broad exposure to Europe. About 58 percent of this exchange-traded fund’s (ETF) $554 million in assets are devoted to the region. Investing in European equities may seem ill-advised given the Continent’s ongoing sovereign-debt crisis. But Europe’s policymakers have already begun to take actions to right the region’s economic ship. Furthermore, SPDR S&P International Dividend’s focus on quality names provides investors with a measure of security.
Although the fund tracks 100 of the highest yielding common stocks in its coverage universe, it doesn’t blindly invest in the companies with the highest yields. Portfolio companies must have a market cap greater than USD1.5 billion and positive earnings growth over the trailing five-year period. The shares of these companies must also be extremely liquid. The economic turmoil of the past few years has narrowed the fund’s European exposure to defensive sectors such as utilities and consumer staples. Although the fund currently allocates 10.8 percent of its assets to the financial sector, Asian and Australian names account for the bulk of that exposure. European financial stocks represent only 0.7 percent of the ETF’s portfolio.
The ETF is slightly more volatile than the S&P 500. But I believe Europe will stabilize eventually, which justifies the fund’s slightly elevated risk.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.