The ETRACS products are exchange-traded notes [ETNs] offered by UBS that cover a range of equity, debt and alternative asset classes (see previous summaries here: I, II). A number of these notes are 2x leveraged, meaning that every $1 invested into the fund effectively controls $2 of assets. Interestingly, while most 2x and 3x leveraged funds on the market reset their leverage daily, the ETRACS 2x ETNs have a monthly resetting mechanism. What this means is that the indicative value of the 2x ETNs will track twice the return of the underlying index since the previous month's close.
The monthly rather than daily leverage resetting mechanism has interesting consequences. On the one hand, it can protect against the leverage decay or beta-slippage that occurs when the underlying index is volatile but does not change greatly in price. For a live example of just how deadly this decay can be, consider the price action of the Direxion Daily Gold Miners Bull 3X Shares ETF (NYSEARCA:NUGT) and the Direxion Daily Gold Miners Bear 3X Shares ETF (NYSEARCA:DUST) this month. Both funds are 3x leveraged and reset their leverage daily.
The Market Vectors Gold Miners ETF (NYSEARCA:GDX) appreciated by 2.83% in January (not shown in chart). Based on this you might expect a 3x bull fund to return thrice that, at +8.49%, and the 3x bear fund to return -8.49%. This would have been true had both ETFs been monthly-resetting funds. Unfortunately, both NUGT and DUST did far worse than expected, at +2.64% and -15.6%, respectively. The reason for this can be explain by leverage decay. As can be seen in the chart above, NUGT went up, and then down, and then back up this month. Every time the index reverses direction, both 3x bull and bear funds will suffer from decay.
(While shorting both sides of daily-resetting leveraged ETFs seems like a sure-fire way to profit from leverage decay, it's definitely something that is easier said than done).
Monthly-resetting protects against decay but magnifies losses during sustained declines
However, while the monthly-resetting mechanism protects against leverage decay, it does introduce a drawback, which is that consistent declines become magnified. As holders of 2xMonthly Leveraged Long Alerian MLP Infrastructure Index ETN (NYSEARCA:MLPL) and 2xMonthly Leveraged S&P MLPV Index ETN (NYSEARCA:MLPV) could attest to, the slide in MLP prices meant that the daily losses in the 2x funds towards the end of the month were far exceeding twice those of the corresponding 1x fund (see "Explaining the Action in MLPL"). I wrote:
In practice, what this means is that when the index has already declined significantly during the month, any further changes are disproportionately (i.e. greater than 2x) magnified in the 2x fund.
This is great news for those with functioning crystal balls, as any rallies from that low point will be amplified (again, by more than 2x) in the 2x fund. However, the unlucky souls who lack that foresight may find themselves in a falling knife situation where each cut hurts more than the last, due to the very way that the monthly reset mechanism works.
So if monthly-resetting leveraged funds suffer greater daily losses than daily-resetting funds on the way down, what happens to them on the way up? This article seeks to address that question.
A theoretical model
My previous article used MLPL as a case study for what happens to 2x leveraged monthly-resetting ETNs when the underlying index declines significantly in a month. The index for MLPL had slumped by over 30% by Jan. 20th, which both triggered a mandatory acceleration event for MLPL (and MLPV), as well as provided me with the necessary data to conduct my analyses.
I looked for a similar period in history where the index for any of the ETRACS 2x ETNs appreciated by 30% in value, but alas, none could be found. Over the course of existence of the ETRACS ETNs (several years), there were only a few months in which the underlying indices registered gains of about 10% (and none more than 15%), which is much too low for any significant differences between monthly and daily-resetting funds to emerge. Thus, I had to construct a theoretical model in order to investigate this issue.
Scenario #1 - increasing for five days
Consider a 1x fund that increases by +10% each day for five consecutive days. A 2x daily-resetting fund will see its value increase by +20% each day. However, a 2x monthly-resetting fund will behave differently; its return at each day must match twice the cumulative return of the 1x fund since the previous month end. The following chart shows the cumulative return values for the 1x fund, the daily 2x fund, and the monthly 2x fund for each day.
As can be seen from the above chart, the monthly-resetting 2x fund lagged the daily-resetting fund during a period of sustained advances. Yet, it's doing exactly what it's supposed to do. On each day, the cumulative return of the monthly-resetting 2x fund is exactly twice that of the 1x fund.
Now, let's consider the daily returns of the three funds. The chart below shows that while the daily returns of the daily-resetting 2x funds are always twice those of the 1x fund, the corresponding monthly-reset 2x fund will experience gradual decreases in % daily change even though the underlying 1x fund is increasing by the same percentage each day.
The above analysis clearly shows that the monthly-resetting 2x fund will underperform the daily-resetting 1x fund during periods of consistent gains. On the face of it, this is an undesirable result for investors in the ETRACS 2x ETNs. Not only does the monthly reset mechanism cause the 2x ETNs to magnify losses during sustained declines (as shown in my previous article), but it also causes gains to be muted during sustained advances!
Scenario #2 - increasing for five days, then decreasing for five days
It's not all doom and gloom, however. Consider what happens if after increasing for five days straight, the index then declines by -9.09% each day for five days. The follow chart shows the cumulative returns for the three funds over the 10 days.
We can see from the above chart that leverage decay hurts the daily-resetting 2x fund, but not the monthly-resetting 2x fund. Although the daily 2x fund leads the monthly 2x fund for all five days of advances as well as for the first day of decline, it begins to lag from the 7th day (2nd day of decline) onwards. On the 10th day, both the 1x fund and the monthly 2x fund have "reset" back to their original level, while the daily 2x fund is sitting on a loss of -8.8%.
We next turn to the daily changes of the three funds. The chart below shows that when the index reverses course and starts declining, the monthly 2x fund actually decreases by less than expected. For example, on day 6 (1st day of decline), the 1x decreases by -9.09% and the daily 2x fund declines by twice that, at -18.18%. However, the monthly 2x "only" decreases by -13.18%. This suggests that when the index has already advanced significantly in a month, owning the monthly 2x fund instead of the daily 1x fund can offer some degree of protection against a reversal in the index.
Implications for investors
As mentioned previously, the above results and conclusions were based on a hypothetical model, due to the lack of historical examples whereby an underlying index for a 2x fund has appreciated significantly (20%+) in a month. Obviously, in real life it is highly unlikely for an index to advance by exactly 10% for five consecutive days. Yet, I believe that the overall relationships that I determined are still valid, and by putting this information out there, I hope that investors would become better prepared should a comparably bullish situation occur.
The main finding from this article is that if the underlying index has already significantly appreciated in the month, any further gains in the index will be muted (i.e. less than 2x) in the monthly-resetting 2x fund. This is opposite to what happens when the index has already significantly declined - subsequent losses are magnified. While this sounds like a lose-lose situation, keep in mind that if the index reverses direction, the monthly 2x fund outperforms. In other words, rallies from the low point are amplified, while declines from a peak are cushioned. Moreover, the monthly 2x fund can reduce decay compared to a daily 2x fund during periods of heightened volatility. Indeed, four out of five ETRACS 2x ETNs that I studied outperformed their hypothetical daily-resetting counterparts since inception.
The above discussion is summarized in the table below. Bolded outcomes indicate situations where the monthly 2x fund outperforms a daily 2x fund.
|Index is significantly above previous month end||Index is significantly below previous month end|
|Subsequent index increase||Gains muted (monthly 2x fund underperforms)||Gains magnified (monthly 2x fund outperforms)|
|Subsequent index decrease||Losses muted (monthly 2x fund outperforms)||Losses magnified (monthly 2x fund underperforms)|
Another way of presenting this information is to consider whether a monthly 2x fund or a daily 2x fund would be more suitable depending on circumstance as well as sentiment. Also shown in the table is the "effective leverage" [EL] of the funds, a metric that I devised that shows the ratio of the daily price movements of a 2x fund in relation to the index. A daily-resetting 2x fund always has an EL of 2, whereas a monthly-resetting 2x fund can have EL values of greater or lesser than 2 depending on the index position.
|Index is significantly above previous month end||Index is significantly below previous month end|
|Highly bullish ("I want to maximize gains and I am willing to accept higher losses!")||Daily 2x fund (EL = 2)||Monthly 2x fund (EL > 2)|
|Slightly bullish ("I still want to obtain leveraged exposure to the index but I want to reduce losses from this point onwards")||Monthly 2x fund (EL < 2)||Daily 2x fund (EL = 2)|
I hope this information has been useful to investors in the ETRACS 2x ETNs.
ETRACS 2x ETNs: (NYSEARCA:DVYL), (NYSEARCA:SDYL), (NYSEARCA:SPLX), (NYSEARCA:CEFL), (NYSEARCA:DVHL), (NYSEARCA:BDCL), (NYSEARCA:MORL), (NYSEARCA:LMLP), (NYSEARCA:LRET), (NYSEARCA:HOML), (NYSEARCA:HDLV), (NYSEARCA:SMHD), (NYSEARCA:RWXL)
Disclosure: I am/we are long BDCL, MORL, HDLV.
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.