CEFL: What Are You Paying For The Privilege?

| About: UBS ETRACS (CEFL)

Summary

We focus on management and financing fees incurred when holding CEFL.

We estimate costs of 0.35% and 4.20% on a monthly and annual basis.

These costs run to about 20% of the latest distribution rate.

Financing costs have risen 40% in 2016.

CEFL has rallied strongly over the last few months and we do not recommend adding risk on a technical or fundamental basis.

CEFL (NYSEARCA:CEFL) has rallied nearly 50% from the market mini-crash earlier this year which represents one of the biggest reversals in 2016. Apart from the massive rally, this ETN attracts a lot of attention because of its high distribution rate which at the moment stands at 18% (on a 12-month trailing basis). A key consideration, which is often missed however, is exactly how much are you paying for the privilege of the high distribution? In this piece, we try to get a handle on this figure. This piece assumes some familiarity with CEFL - for the uninitiated we can recommend many high-quality overviews provided by other contributors or (for the particularly brave) the product and pricing supplements.

At the outset we should say that it's not possible to itemize all the fees that accrue to a long CEFL position. This is because we don't have full transparency of the actual trading carried out by the constituent funds, custody fees paid by their managers, bid/offer spreads on their trades, detailed borrowing costs etc etc. However, it is possible to get a ballpark picture of the key amounts. For the purpose of this piece, the total fees comprise:

  • CEFL Financing Fee
  • CEFL Tracking Fee
  • Constituent Fund Expenses

Below we run through these three components but the chart below cuts to the chase:

Source: Bloomberg

To summarize the chart above:

  • Blue bars represent the 0.50% Tracking Fee (left-axis)
  • Red bars repersent the 1-Month Libor + 0.40% Financing Fee (left-axis)
  • Green bars represent the Constituent Fund Fees (left-axis)
  • The line represents the cumulative sum of the fees above for 2016 (right-axis)

CEFL Financing Fee

This is a fee on the provision of leverage by UBS and is paid on the principal amount. The reason this fee is linked to the Libor index is because it reflects broadly the cost of raising funds by UBS in order to provide the additional turn of leverage in the fund. The fee runs to 1-Month Libor + 0.40% and accrues monthly.

Source: Bloomberg

At the end of September, 1-Month Libor stood at 0.53% so the total Financing Fee, assuming this fixing, would be 0.93% for the month of October. The key thing to note in the chart is the jump in 1-Month Libor which is driven by new money market regulations which we will not go into here. The net impact of these regulations has been to increase the Financing Fee from around 0.55% to around 0.90%. This fee is accrued on an Actual360 basis.

CEFL Tracking Fee

This is a flat fee currently set to 0.50% which can be thought of as a typical expense fee. This fee is relatively low as far as expenses go, however, it is important to keep in mind that managing CEFL requires no discretionary decisions (apart perhaps from trading the annual rebalancing). This fee is accrued on a Actual365 basis.

Constituent Fund Expenses

Apart from the fees on CEFL itself, there are fees embedded into the actual funds wrapped into CEFL. The expense ratios of these funds range from 0.6 to 2.8 with the weighted-average expense ratio at 1.4. It is important to note that because of the leverage embedded in CEFL, investors are effectively paying these fees twice.

Now that we have itemized the key fee structure of CEFL we can answer the question posed at the beginning of this piece - how much of the distribution are you paying in fees?

If we look at the most recent fees (0.35%) and distributions (1.80%) we calculate that on a net basis we are paying 20% on a net basis (fees / dividends) and 16% on a gross basis (adding the fees back into the dividends in the denominator).

While this looks high - the real questions to ask is 1) where could you get financing if you were to leverage the constituent funds yourself and 2) is it worth taking double exposure on the constituent funds while taking home on 80%-85% of the rewards. We would suggest the answer to the first question would be sufficiently high as to make the rate offered by UBS downright cheap. The answer to the second question cannot be answered by us and depends ultimately on the utility function of each individual investor.

Finally, to wrap up this piece - we must deal with the elephant in the room. That is, apart from the fee breakdown - does CEFL look investable at the moment? Our thesis can be broken down into the following points:

  • Historically massive rallies as we have seen over the last few months suggest poor near-term returns for CEFL
  • Constituent fund premium/discount valuations have rallied strongly off the lows and no longer offer a bargain
  • Significant event risk is on the horizon: US election, ECB QE tapering and potential Fed action
  • High Yield and Equity markets are trading close to the year highs in an extended business cycle and worsening corporate metrics

That wraps it up - for now, Good Luck.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.