CEFL: A Year In Review, And A Prediction Of What's Ahead

| About: UBS ETRACS (CEFL)

Summary

2015 has not been a good year for CEFL unitholders: income declined by 20% while price declined by 33%.

This article presents a review of CEFL happenings in 2015, and a forecast of what's ahead for 2016.

Based on the publicly available index methodology, the CEFs to be added or removed are predicted.

Introduction

The ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN (NYSEARCA:CEFL) is a 2x leveraged exchange-traded note [ETN] that tracks twice the monthly performance of the ISE High Income Index [symbol YLDA]. The YieldShares High Income ETF (NYSEARCA:YYY) tracks the same index, but is unleveraged. CEFL is a popular investment vehicle among retail investors due to its high income (24.52% trailing twelve months yield), which is paid monthly. With 2015 nearly behind us, I thought I would review the characteristics of this year's iteration of CEFL, and also look ahead at what might be in store for us in 2016.

(Source: Main Street Investor)

2015 portfolio

YLDA holds 30 closed-end funds [CEFs], and is rebalanced annually. As I have previously discussed in my three-part "X-raying CEFL" series, this year's iteration of CEFL (and thus also YYY) had the following characteristics:

  • CEFL is comprised of approximately one-third equity and two-thirds debt, is effectively leveraged by 240% and has a total expense ratio of 4.92% per dollar invested in the fund (or 2.05% per dollar of assets controlled) (discussed in "X-Raying CEFL: Leverage And Expense Ratio Statistics").
  • CEFL contained around two-thirds of North American (primarily U.S.) assets, with the rest being international. Moreover, the North American component of CEFL contains a higher allocation to debt vs. equity than the European component of CEFL (discussed in "X-Raying CEFL (Part 2): Geographical Distribution").
  • CEFL is not very interest-rate sensitive as most of the holdings of CEFL are most-correlated with high-yield debt (discussed in "X-Raying CEFL (Part 3): Interest Rate Sensitivity").

Actually, I might have been inaccurate in my last prediction. Over the last year, the price action of CEFL has actually moved in the same direction to interest rates, which is exactly opposite to what would be expected for a traditional bond fund. But this is not entirely surprising for CEFL, because high-yield debt usually tend to trade in tandem with equities and in the opposite direction to treasuries. Indeed, CEFL had a positive +0.71 correlation with U.S. equities (via SPDR S&P 500 ETF (NYSEARCA:SPY) over the past year, but a negative -0.24 correlation with treasuries (via the iShares 20+ Year Treasury Bond ETF) (NYSEARCA:TLT) (source: InvestSpy). Thus, readers who worried that higher interest rates would lower the price of CEFL may actually have been pleasantly surprised that the opposite has held true this year.

CEFL Total Return Price Chart

Decreasing yield

Seeking Alpha author Professor Lance Brofman has done a wonderful job predicting the upcoming distributions for CEFL (see his latest article here), while also providing expert commentary in his area of expertise.

The distribution history for CEFL, which now has paid out 24 months of dividends, is presented below.

Unfortunately, we see that the distributions paid out by CEFL have been in decline. In 2014, each share of CEFL paid out $4.74 of distributions, but in 2015, each share of CEFL only paid out $3.82 of distributions. This means that the distribution of CEFL has declined by 19.5% year on year. I believe that a large reason for the distribution decline can be attributed to the rebalancing debacle that occurred at the turn of this year (see below).

CEFL has a current trailing twelve months yield of 24.52%.

Rebalancing debacle

The annual rebalancing in the index YLDA was disastrous for CEFL and YYY holders last year. The reasons for this have been summarized in my recent article "Are You Ready For CEFL's Year-End Rebalancing?" In short, up to 10% of the net asset value of CEFL may have been lost due to traders (including, perhaps, UBS themselves) buying and selling the CEFs to be added or removed from the index ahead of the actual rebalancing date (a form of "front-running," see this Bloomberg article for more information on this phenomenon). For further study on the rebalancing issue, consult my previous articles on this issue in the below links:

Predicting the 2016 portfolio

How might the portfolio of CEFL change upon the next rebalancing event, which is scheduled to occur in the next few days? As discussed in my most recent CEFL article, the index provider has decided that the upcoming index will not be announced 5 days in advance. I believe that this change was enacted in order to prevent "front-running" of the index. However, with the index methodology published and available to all, I had little doubt that professional investors would be able to use the selection rules to determine which stocks would be added or removed from the index. Therefore, in an attempt to level the playing field for everyone else, I have tried to approximate the index methodology in order to predict CEFL's portfolio for 2016.

The selection methodology for the index is reproduced below (source: ISE).

1. Restrict selection universe to closed-end funds with market cap >$500M and six month daily average volume > $1M.

2. Rank each fund by the following three criteria:

  • i. Fund yield (descending)
  • ii. Fund share price Premium / Discount to Net Asset Value (ascending)
  • iii. Fund Average Daily Value (Pending:ADV) of shares traded (descending)

3. Calculate an overall rank for each fund by taking the weighted average of the three ranks with the following weightings: yield: 50%, premium/discount: 25%, average daily value: 25%.

4. Select the 30 funds with the highest overall rank.

Using CEFAnalyzer, I obtained a list of the 141 CEFs with market cap >$500M. Unfortunately, I was unable to apply a volume filter because I was not sure what specific time period CEFAnalyzer reports volume data for. I then replicated the index methodology for the 141 CEFs on this list.

The below table shows the top 30 CEFs for either distribution yield or discount among the CEFs with market cap >$500M.

Rank Ticker Yield Rank Ticker Discount
1 GGN 17.14% 1 BCX -16.92%
2 PHK 14.58% 2 AOD -16.88%
3 KYN 14.44% 3 AWP -16.29%
4 NHF 14.23% 4 IGR -16.19%
5 HIX 13.06% 5 FAX -16.09%
6 TDF 13.03% 6 RNP -15.64%
7 IGD 12.67% 7 GLO -15.33%
8 RVT 12.40% 8 RVT -15.07%
9 CEM 11.73% 9 NFJ -15.04%
10 PTY 11.69% 10 DPG -15.04%
11 GLO 11.37% 11 UTF -14.93%
12 GAB 11.21% 12 ADX -14.92%
13 EXG 11.17% 13 TY -14.81%
14 BCX 11.12% 14 WIW -14.79%
15 CHI 11.11% 15 TDF -14.63%
16 ETJ 11.05% 16 NXJ -14.58%
17 EAD 10.94% 17 NHF -14.57%
18 DSL 10.89% 18 NIE -13.63%
19 CHY 10.89% 19 NQP -13.40%
20 PFN 10.75% 20 USA -13.32%
21 PCI 10.74% 21 FSD -13.31%
22 FEI 10.44% 22 BIT -13.04%
23 ETW 10.36% 23 GDV -12.81%
24 AWP 10.24% 24 JQC -12.70%
25 NTG 9.95% 25 CAF -12.50%
26 PCN 9.86% 26 IGD -12.41%
27 CSQ 9.81% 27 VTA -12.33%
28 PDI 9.62% 28 RQI -12.27%
29 NFJ 9.62% 29 BDJ -12.10%
30 EVV 9.59% 30 NQU -12.04%

The yield ranking was then weighted by 50% while the discount ranking was weighted by 25% (the rankings are assigned to all 141 CEFs, and not only to the top 30). The ranking for volume is not shown above because as I mentioned earlier, I was not sure about the time period used by CEFAnalyzer to calculate volume. Nevertheless, because I did not have time nor inclination to manually calculate the ADV for 141 CEFs, the CEFAnalyzer volume data was still used to obtain a volume ranking for the funds, which was weighted by 25%.

The weighted rankings were then summed, and the top 30 CEFs with the highest overall ranking are shown below, along with their composite individual ranks. A quick check on Yahoo Finance indicated that the 3-month ADV of these 30 CEFs was above the $1M cut-off (which is actually for the 6-month ADV, but I did not calculate this).

Rank Ticker Yield Discount Volume Overall
1 (NYSE:RVT) 8 8 18 10.50
2 (NYSE:BCX) 14 1 25 13.50
3 (NYSEMKT:GGN) 1 42 16 15.00
4 (NYSEMKT:GLO) 11 7 39 17.00
5 (NYSE:NFJ) 29 9 15 20.50
6 (NYSE:IGD) 7 26 48 22.00
7 (NYSE:EXG) 13 50 13 22.25
8 (NYSE:PCI) 21 39 11 23.00
9 (NYSE:HIX) 5 79 12 25.25
10 (NYSEMKT:EVV) 30 35 17 28.00
11 (NYSE:DPG) 33 10 38 28.50
12 (NYSE:AOD) 44 2 24 28.50
13 (NYSE:NHF) 4 17 96 30.25
14 (NYSE:DSL) 18 77 8 30.25
15 (NYSE:CEM) 9 100 5 30.75
16 (NASDAQ:CSQ) 27 52 19 31.25
17 (NYSE:KYN) 3 119 2 31.75
18 (NASDAQ:CHI) 15 96 1 31.75
19 (NYSE:TDF) 6 15 104 32.75
20 (NYSE:AWP) 24 3 83 33.50
21 (NYSE:USA) 31 20 58 35.00
22 (NYSE:BGB) 36 46 26 36.00
23 (NYSE:NTG) 25 88 6 36.00
24 (NYSE:FEI) 22 97 7 37.00
25 (NYSE:BIT) 47 22 32 37.00
26 (NYSE:UTF) 54 11 29 37.00
27 (NYSE:BOE) 40 41 30 37.75
28 (NYSE:GHY) 39 47 27 38.00
29 (NYSE:ETJ) 16 56 71 39.75
30 (NYSEMKT:FAX) 41 5 72 39.75

The following table shows the same 30 CEFs as above but with their actual yield, discount and volume values.

Rank Ticker Yield Discount Volume / $M
1 RVT 12.40% -15.07% 2.99
2 BCX 11.12% -16.92% 2.58
3 GGN 17.14% -10.93% 3.64
4 GLO 11.37% -15.33% 1.66
5 NFJ 9.62% -15.04% 4.21
6 IGD 12.67% -12.41% 1.49
7 EXG 11.17% -10.45% 4.28
8 PCI 10.74% -11.06% 4.54
9 HIX 13.06% -8.25% 4.48
10 EVV 9.59% -11.36% 3.07
11 DPG 9.46% -15.04% 1.71
12 AOD 8.93% -16.88% 2.60
13 NHF 14.23% -14.57% 0.74
14 DSL 10.89% -8.47% 4.95
15 CEM 11.73% -6.02% 6.10
16 CSQ 9.81% -10.31% 2.80
17 KYN 14.44% -3.09% 13.27
18 CHI 11.11% -6.56% 19.98
19 TDF 13.03% -14.63% 0.68
20 AWP 10.24% -16.29% 0.89
21 USA 9.51% -13.32% 1.33
22 BGB 9.23% -10.60% 2.38
23 NTG 9.95% -7.57% 5.71
24 FEI 10.44% -6.53% 5.03
25 BIT 8.75% -13.04% 2.00
26 UTF 8.39% -14.93% 2.21
27 BOE 9.13% -10.96% 2.17
28 GHY 9.16% -10.55% 2.36
29 ETJ 11.05% -9.89% 1.15
30 FAX 9.05% -16.09% 1.13

At this point, I would like to compare notes with reader waldschm85:

I've attempted to follow the index methodology and came up with the below holdings from largest to smallest as of the open. How does this compare to your list Stanford Chemist?:

BCX, TDF, GGN, RVT, KYN, PCI, NFJ, NTG, IGD, NHF, EXG, CSQ, GLO, DPG, CEM, FEI, CHY, DSL, CHI, USA, HIX, PHK, GAB, TYG, EAD, ETJ, PTY, ETW, PFN, PCN

Comparison of our two lists show that we have 20 out of 30 CEFs in common, which is quite high considering that [i] we did our analyses several days apart and [ii] I used an unspecified volume figure for ADV ranking while waldschm85 may have used a more accurate method.

The weighting methodology states that no CEF can comprise more than 4.25% of the index. However, the exact weighting algorithm is too complex to be reproduced here.

The CEF weighting profile resulting from last year's rebalance is shown below. It can be seen that the 15 largest CEFs all had weights of above 4%. I expect the allocation profile of the 30 CEFs after this year's rebalance to be quite similar to the last year's profile.

Additions and deletions (predicted)

Here we get to the interesting part! Which funds are completely new, and which will be completely removed? Which CEFs are in both 2015 and 2016 (predicted) portfolios? The following will be performed with my list of top 30 CEFs - obviously results will differ using waldschm85's list or that of another person's. CEFs are presented in alphabetical order.

  • Added CEFs: BCX, BOE, CEM, CHI, CSQ, DPG, ETJ, FEI, KYN, NFJ, NHF, NTG, RVT, TDF, USA, UTF
  • Removed CEFs: BGY, CHW, EAD, EDD, ERC, ESD, ETY, FPF, HYT, ISD, JPC, MRC, MMT, NCV, NCZ
  • CEFs that remain from last year: AOD, AWP, BGB, BIT, DSL, EVV, EXG, FAX, GGN, GHY, GLO, HIX, IGD, PCI

The information above shows that 16 CEFs will be added to the index and 16 will be removed. 14 CEFs will remain in the index. This is a relatively high turnover but it is not unexpected given the fact that both the distributions and premium/discount values of CEFs can vary erratically. Moreover, given that I did not calculate weightings for the 2016 portfolio, I was unable to predict which CEFs will undergo the highest increases or decreases in allocation.

However, it should be stressed that the above lists are only approximate. This is because I only performed a crude replication of the index methodology (specifically, I did not use the six-month ADV for either screening or ranking), and also because of the fact that the actual selection and ranking algorithm will be performed by the index provider on the CEF data from a particular date that might not necessarily be the same as the date on which I obtained my data (Dec 27th, 2015). Therefore, I am hesitant to recommend the buying of the CEFs to be added and the selling of CEFs to be removed as a potential strategy to profit from the upcoming rebalance. Use the information above at your own risk.

Summary

2015 has not been a good year for CEFL unitholders. First, the botched rebalancing mechanism cause permanent loss of value in the index. Second, CEFL holders received 19.5% less income in 2015 compared to last year (this may be related to the first point). Third, CEFL shifted from a 60/40 equity/bond split in 2014 to a 33/67 equity/bond split this year, just in time for the oil collapse-induced credit contagion to wreck havoc with the high-yield debt CEFs in the index. Certainly, a -32.7% YTD price return and -18.4% YTD total return cannot be described as anything other than disappointing for CEFL unitholders.

CEFL Chart

CEFL data by YCharts

Will 2016 bring brighter skies for CEFL? This I cannot say for certain. However, it is interesting to note that the predicted portfolio for 2016 contains several MLP CEFs, namely KYN, CEM, NTG, and FEI, whereas this year's index contained none. Moreover, a myriad of high-yield bond funds will remain or are newly added to the predicted 2016 portfolio. Thus, it remains likely that the fate of CEFL will remain closely tied with the fortunes of the high-yield credit market for the foreseeable future.

Disclosure: I am/we are long CEFL.

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.

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