YMBC - A Very High Yield, Leveraged Portfolio - One Year Review

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Includes: AGNC, BDCL, CEFL, CYS, DVHL, EFF, LMLP, MLPL, MORL, NLY, PHK, PSEC, SDYL, SPY, WMC
by: Darren McCammon

Summary

The YMBC (You Must Be Crazy) portfolio is a portfolio comprised mainly of UBS 2x leveraged ETN's.

The YMBC Portfolio outperformed both the S&P 500 & Russell 2000 in 2014 while maintaining a double digit dividend.

Analysis indicates the portfolio may be only somewhat more risky than the market.

Learning's and strategy adjustments for 2015.

The YMBC (You Must Be Crazy) High Yield Portfolio was first introduced to readers in an Instablog post located here. Since it has been in existence for a year now I thought I would publish an article on it.

Overview:

The YMBC portfolio was designed with a few specific challenges in mind. The actual account was a small inherited beneficiary IRA which represents less than 4% of the my overall investments. Despite small size, the portfolio attempts to utilize the tax advantage of being in an IRA, take advantage of diversification opportunities and fund a required minimum distribution (RMD).

In designing the portfolio attention was paid to utilizing high dividend yield, pass through securities. Numerous studies have shown not only that dividend paying equities produce better risk adjusted returns but that higher dividends tended to improve these returns. Additionally, other studies and articles on pass through securities (MLP's, mREIT's, REIT's, BDC's, CEF's, Marshall Island Limited Partnerships, etc.) have shown not only generally high yields, but indicated they may have two fundamental advantages over normal C corporation securities. First, pass through securities do not have to pay corporate tax and thus do not suffer from double taxation (corporate taxes then dividend taxes) as do normal stocks. Second, the required payout of almost all distributive cash flow to the investor places some important and useful checks and balances on management. When management wants to fund growth or a significant project, they cannot just do so from existing cash flow. Rather they have to either ask the investor for more funds via a securities offering or borrow it from a bank. This at least in theory, provides a check on management empire building.

An attempt to keep expenses down was also made by utilizing ETFs or ETNs of high yield pass through securities.

Last, though this account does have an RMD, the investor is not a retiree and is willing to take on market or even above market risk in order to try to achieve higher total returns. Ultimately it was decided to focus the portfolio mainly on 2x ETNs from UBS. (Note, it bears repeating that this is a real money test in a risky basket of ETNs, but one which also encompasses less than 4% of my overall investments.)

At the beginning of 2014, nutty guy that I am, I chose to invest the portfolio as follows:

  • 30% MORL -UBS ETRACS Monthly Pay 2x Leveraged Mortgage REIT ETN (overweight due to my call that it was cheap)
  • 20% CEFL -UBS ETRACS Monthly Pay 2xLeveraged Closed - End Fund ETN
  • 20% DVHL -UBS ETRACS Monthly Pay 2xLeveraged Diversified High Income ETN
  • 20% SDYL -UBS ETRACS Monthly Pay 2x Leveraged S&P Dividend ETN
  • 5% BDCL -UBS ETRACS 2X Leveraged Long Wells Fargo Business Development Company ETN
  • 5% EFF -Eaton Vance Floating-Rate Income Plus Fund

This combination throws off >5% in income each quarter (>20% / year), so just one quarterly distribution more than funds the RMD while the other three are re-invested. Overall expenses are acceptable at less than 2% overall (.85% tracking fee, .5% leverage fee, .5% re-investment costs from combined trading fee's and bid/ask spreads). I saw the portfolio as 45% risky with relatively high correlation to the S&P (SDYL, BDCL, CEFL), 50% risky with low correlation to the S&P (MORL, DVHL), and 5% with lower risk and return but benefiting from higher rates . Overall the goal was to maintain about market risk and return but with much higher yield. It was my hope that the increased risk of 2x leverage will be largely offset by the increased diversification provided by asset mix (more on this later in the risk section).

Returns:

The YMBC portfolio ended 2014 up 13.1% vs. 11.4% for the S&P 500 and 3.5% for the Russell 2000. It produced about 15.8% in yield, 2% of which was taken as an RMD, with the other 13.8% re-invested. YMBC experienced two significant draw downs during the year. The first starting in mid-September corresponded to a decline in the overall market as well as greater than average declines in components BDCL and CEFL. The second in mid-December was due to a significant over-weighting in BDCL being placed two trading days before that ETN plummeted to its' greatest losses of the year (PSEC, BDCLs' largest component, cut its dividend negatively affected all BDC's and BDCL). Despite this very poor timing, the YMBC portfolio outperformed both the S&P 500 and the Russell 2000 while maintaining a double digit dividend yield.

Risk: (note risk data is from a mid-2014 analysis posted to my Instablog located here. I did not update it for this article.)

Most people think of risk as the risk of losing money. Fair enough. However, many focus on the risk of losing money in a particular stock instead of considering how that particular stock ownership would affect the risk of losing money for the entire portfolio. The two can be very different. I submit it is not the risk of losing money in a stock that the reader should care about, rather it is the risk of losing money over one's entire portfolio.

Here is an example that might help get my point across:

  • Annaly Capital Management, Inc. (NYSE:NLY): Dividend 10.3%, Volatility* 12.9
  • American Capital Agency Corp. (NASDAQ:AGNC): Dividend 11.0%, Volatility* 12.3
  • CYS Investments, Inc. (NYSE:CYS): Dividend 14.5%, Volatility* 17.3
  • Western Asset Mortgage Capital Corporation (NYSE:WMC): Dividend 17.9%, Volatility* 21.8
  • MORL: Dividend 24.5%, Volatility* 13.9

Many people, if they were going to invest in the mREIT space, would choose NLY, the largest and best known of the mREITs. They do so thinking NLY less risky, certainly less risky than MORL (a 2x leveraged ETN in the space). But look closer, even though MORL is composed entirely of mREITs, there does appear to be some diversification benefit from holding MORL. It's volatility is not 2x of the other mREIT's but rather is a middle of the pack 13.9. The diversification offered by MORL appears to be largely offsetting the increased volatility of it being leveraged 2x. Put another way, $10k invested in NLY would generate about $1k in annual yield. A better alternative may be putting $5k in MORL with the other $5k in a CD. This would produce both more income and less risk.

The YMBC portfolio is primarily designed to produce a very high yield; however, overall portfolio risk was also a significant consideration. If possible, I wanted a portfolio which had risk comparable to the overall market. It appears that goal has been achieved, at least through mid-2014 when I completed this analysis. The Sharpe, Treynor and Sortino values for the YMBC portfolio were all positive for 2014. For those who may not have a PhD in finance, here is a graphical representation which may explain better than quoting positive Sharpe, Treynor and Sortino values (provided with my thanks by macroaxis.com):

As you can see the YMBC portfolio (marked Current Portfolio in the graphic above) is performing better than the S&P 500 (marked Market in the graphic above). It has both a better return (left axis) and a lower risk score (bottom axis). Yes, it is possible to beat the market; you can even beat it and produce high yield. Next please look at the smaller gray circles in the graph. Each represents a different component (e.g. MORL, BDCL, etc.) of the overall portfolio. Note that while almost all of them are more risky than the market (to the right on the graph) however the combination of them (Current Portfolio) is actually less risky than the market. This is because these components have different traits, when some of them zig, others tend to zag. Or in finance terms, they have low correlation coefficients (more on this later).

Now I like the YMBC portfolio as is; however, I realize many readers would be happier with high yield, market like returns and less risk. So in this next graphic I added cash until the return of YMBC portfolio equaled that of the market.

Using the scale on the left, you can see the current portfolio now has the same return as the market. The return has declined because I have added 25% cash to the portfolio, enough to bring its' return down to that of the market. The Current Portfolio in this second graphic represents 75% YMBC and 25% cash. This revised Current Portfolio now has return equal to the market, a double digit yield and a risk score almost half that of the market (.35 vs. the markets .63). For those of you with a more conservative nature, this may be a better option.

Now, back to the correlation coefficients:

They are the magic that makes better portfolio return with less risk possible. A number of 1 means the two assets tend to move in lockstep with each other. One would expect the SPDR S&P 500 Trust ETF (NYSEARCA:SPY), and the S&P 500 Index to have a correlation coefficient very close to 1. The highest correlation between the portfolio components, at .55, is between SDYL and BDCL (bright green). About half the movement in one can be associated with the movement of the other. Most of the other correlations however, the orange one's, are very close to 0. This means those assets have very little in common. When one goes up 20%, it tells you almost nothing about what the other one is going to do. In other words, when one zigs, the other may zag. While each individual component in the portfolio may have risk greater than the market, this is what causes the overall portfolio to maintain a risk less than the market.

In the end, isn't risk more about not losing money than not having an a particular asset which lost money?

Changes to the YMBC Portfolio going into 2015:

In the first three quarters of 2014 I followed the original plan. I reinvesting the distribution income in whichever category had declined the most from original purchase, in each case BDCL. Yep, I tried to catch a falling knife and suffered the cuts and a general drag on performance from it.

I also made three other moves in the portfolio.

One, I eliminated CEFL when I realized a couple components of it, PIMCO High Income Fund (NYSE:PHK) being the most prominent, were trading at significant premiums to NAV. CEFs in my opinion, shouldn't be bought at premiums even if there manager is the "King of Bonds." When that star manager departs, well, even more reason for you to depart too. Discount to NAV is supposed to be one of CEFLs prime criteria, so it did not occur to me that inclusion of a CEF with such a large premium could happen. However apparently it can. I immediately sold CEFL from the portfolio when I realized my error. It is my understanding PHX has subsequently been dropped from CEFL as part of it's annual renewal, but I have not confirmed that and have had my confidence in CEFL's selection criteria shaken. So for now I continue to have 0% allocated to CEFL.

Two, I considered addition of the UBS ETRACS 2x Leveraged Long Alerian MLP Infrastructure Index ETN (NYSEARCA:MLPL) or the UBS ETRACS Monthly Pay 2xLeveraged Wells Fargo MLP Ex - Energy ETN (NYSEARCA:LMLP) to the portfolio on the suggestion of other readers. However, since upon further analysis neither appeared cheap to me, nor seemed to add much in the way of diversification, I decided to hold off. I may still add one or both to the portfolio at some future date when they either get cheap or I have had a chance to do a more complete analysis of them.

Three, towards the end of the year I made a conscious decision to significantly overweight BDCL (much as I had MORL in the beginning of 2014). So far this has been very poor timing. BDCL continued to fall, with one of it's greatest declines occurring just two trading days after I decided to overweight. At that time Prospect Capital Corporation , BDCL's largest component, announced they were cutting their dividend. Despite the poor timing, I am sticking with the re-investment strategy. I now have an over-weighted position in what I feel is the cheapest UBS 2x ETN, BDCL. One modification I did decide to make as a result of this was to impose a concentration cap of 30% on the portfolio. If any one component reaches 30% of the portfolio, dividends will not be reinvested in that component even if it is the poorest performer. Instead they will be re-invested in the next poorest performer down the list. Since BDCL is now 30% of the portfolio, if it continues to be the poorest performer come end of Q1 2015, re-invested dividends will fall to the second poorest performer.

As of the beginning of 2015 the YMBC portfolio stands as follows:

  • 30% BDCL (overweight due to my call that it is cheap)
  • 21% MORL
  • 17% DVHL
  • 15% SDYL
  • 0% CEFL, MLPL & LMLP
  • 17% EFF
  • 0% Cash

Indicated Forward Yield: 14.2%

This portfolio is as much a real money test as anything since it represents less than 4% of my overall portfolio. I welcome feedback including negative feedback. All I ask is you give specific backup data justifying why you think I'm such an idiot. If there is sufficient ongoing interest, I will try to continue to post a quarterly update to the Instablog so you all can continue to see and comment on just what a fool I am.

Disclosure: The author is long MORL, BDCL, SDYL, DVHL, EFF, 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.

Additional disclosure: I say right there in the name, if you follow this portfolio YOU MUST BE CRAZY! I don't know who you are much less your particular situation; so how can I recommend this portfolio or for that matter any investment to you? Don't follow a crazy person, do your own due diligence.