ETRACS 2x ETNs - Is Leverage A Friend Or Foe?

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Includes: BDCL, BDCS, CEFL, DVY, DVYL, LRET, MORL, MORT, SDY, SDYL, SPLX, SSO, VNQ, YYY
by: Stanford Chemist

Summary

The ETRACS 2x ETNs reset their leverage monthly rather than daily.

The live performance of the 2x ETNs is compared versus a 200% investment in their 1x counterparts.

On average, we find that the 2x ETNs perform reasonably in line with expected.

Leveraged exchange-traded products (ETFs and ETNs) are a double-edged sword. At one extreme, you have articles such as "Why Leveraged ETFs All Go to Zero", which advises that because of the "mathematical certainty" of leverage decay, leveraged products should never be held for an extended period of time. On the other hand, the "You Must Be Crazy! (YMBC)" portfolio from fellow Seeking Alpha author Darren McCammon has over 50% of its holdings in leveraged ETNs.

The UBS' ETRACS line-up of 2x leveraged ETNs reset leverage monthly (in other words, the performance of the ETN tracks twice the monthly performance of the index) rather than daily, which might reduce the impact of leverage decay. It is also possible to use the 2x leveraged ETNs to replicate a 1x position, possibly with lower fees to boot. I have previously provided overviews of the ETRACS 2x ETN line-up (see latest edition here).

In this article, I wish to look at the live performance of some of the ETRACS 2x leveraged ETNs to see how well they have managed to fulfil their leverage target. Only 2x ETNs with a corresponding 1x fund can be considered.

Short-term

Let's take a look at the short-term performances (1-year) of some of the 2x ETNs vis-a-vis their 1x counterparts.

ETRACS 2xLeveraged Long Wells Fargo Business Development Company Index ETN (NYSEARCA:BDCL) vs. ETRACS Wells Fargo Business Development Company Index ETN (NYSEARCA:BDCS):

BDCL Total Return Price Chart

ETRACS Monthly Pay 2xLeveraged Mortgage REIT ETN (NYSEARCA:MORL) vs. VanEck Vectors Mortgage REIT (NYSEARCA:MORT):

MORL Total Return Price Chart

MORL Total Return Price data by YCharts

ETRACS Monthly Pay 2x Leveraged Closed-End Fund ETN (NYSEARCA:CEFL) vs. YieldShares High Income ETF (NYSEARCA:YYY):

CEFL Total Return Price Chart

ETRACS Monthly Pay 2xLeveraged MSCI US REIT ETN (NYSEARCA:LRET) vs. Vanguard REIT ETF (NYSEARCA:VNQ):

LRET Total Return Price Chart

ETRACS Monthly Pay 2xLeveraged Dow Jones Select Dividend Index ETN (NYSEARCA:DVYL) vs. iShares Dow Jones Select Dividend ETF (NYSEARCA:DVY):

DVYL Total Return Price Chart

ETRACS Monthly Pay 2xLeveraged S&P Dividend ETN (NYSEARCA:SDYL) vs. SPDR S&P Dividend ETF (NYSEARCA:SDY):

SDYL Total Return Price Chart

ETRACS Monthly Reset 2xLeveraged S&P 500 Total Return ETN (NYSEARCA:SPLX) vs. SPDR S&P 500 (NYSEARCA:SPY):

SPLX Total Return Price Chart

The following chart shows the 1-year total return performance of the 2x ETNs ("2x"), their 1x counterparts ("1x") and a 200% investment in the 1x ETN ("2*1x"). Comparing the performance of the 2x ETN with twice the performance of the 1x ETN allows us to determine whether or not the 2x ETNs have reasonably fulfilled their leverage objective. Also plotted on the same axes are the differences between the 2x and 2*1x values, which as we can see below are generally quite small compared to the overall returns.

The data above shows that on average, the 2x ETNs have performed reasonably in line with expectations over the past 1-year period. MORL, DVYL and SDYL have performed slightly better than twice of their 1x counterpart, while BDCL, CEFL, LRET and SPXL have underperformed. The seven 2x ETNs averaged 26.3% in total return over the past year, versus an average of 27.1% for the 200% 1x investment, a minor difference.

Over the longer-term

How about over the longer term? One would expect that the 2x leverage tracking ability of the ETNs would decline as the observation period increases. We consider here ETNs that have been trading for at least several years (about 2.5 years for SPXL, 3 for CEFL, 4 for MORL, 4.5 for DVYL and SDYL, and 5.5 for BDCL).

BDCL vs. BDCS:

BDCL Total Return Price Chart

BDCL Total Return Price data by YCharts

MORL vs. MORT:

MORL Total Return Price Chart

CEFL vs. YYY:

CEFL Total Return Price Chart

CEFL Total Return Price data by YCharts

DVYL vs. DVY:

DVYL Total Return Price Chart

SDYL vs. SDY:

SDYL Total Return Price Chart

SPLX vs. SPY:

SPLX Total Return Price Chart

On the final chart I've also included ProShares Ultra S&P500 ETF (NYSEARCA:SSO), a 2x leveraged fund like SPLX, except that its leverage resets daily instead of monthly like SPLX. We can see that since the inception of SPLX, monthly resetting of leverage has helped performance as compared to daily resetting.

The following chart shows the annualized total return performance of the 2x ETNs ("2x"), their 1x counterparts ("1x") and a 200% investment in the 1x ETN ("2*1x"). Performances are annualized because of the different time spans that were considered for the those ETNs.

The data above shows that even over the longer term, the 2x ETNs have performed reasonably close to as expected. DVYL and SDYL have outperformed a 200% investment in the underlying index, with 30.1% and 31.5% annualized returns respectively since mid-2012, versus 29.4% and 30.9% respectively for the corresponding 200% 1x investment. The biggest underperformer was MORL, which has returned 9.9% annually vs. 13.8% for a 200% investment in MORT.

The six 2x ETNs averaged 17.3% annually, versus 18.2% for the basket of 200% 1x investments, which is again a relatively small difference.

Conclusions

This study was conducted on live performance data for the ETRACS 2x ETNs, some of which have been trading for several years already. We find that over both the short and longer-terms, the 2x ETNs still behave generally as we expect, returning about 200% of the performance of the underlying 1x investment.

We can also make the general observation that if there is a sustained trend in one direction, the 2x ETNs will generally outperform a 200% investment in the underlying 1x instrument (see DVYL and SDYL). Conversely, gyrations in share price would cause a 2x ETN to underperform a 200% investment in the underlying 1x instrument (see CEFL and MORL). However, despite their significant fluctuations, CEFL and MORL still have not inexorably marched towards zero. Therefore, in my view readers should not be unduly concerned about leverage decay eating up the entire value of their leveraged funds, particularly with the monthly-resetting ETRACS 2x ETNs.

Hopefully this information has been helpful to readers considering investments in 2x leveraged ETNs.

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Disclosure: I am/we are long BDCL.

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.