UBS (NYSE:UBS) offers the ETRACS suite of 2x leveraged ETNs that span a range of equity, debt and alternative investment classes (see "A Quick Overview Of UBS ETRACS 2X Leveraged ETNs" and "An Update On UBS's ETRACS 2X Leveraged ETNs" for more information"). These funds are popular among retail investors because of the juicy distribution yields that they pay out.
An interesting feature of the ETRACS 2x leveraged ETNs is that they reset their leverage monthly rather than daily, as is the case for most leveraged ETFs and ETNs on the market. In a recent article entitled: "Has Monthly Resetting Helped Or Hurt The ETRACS 2x Leveraged ETNs?" I found that monthly-resetting of the leverage was beneficial for four out of five ETRACS 2x ETNs, the Monthly Pay 2xLeveraged S&P Dividend ETN (NYSEARCA:SDYL), the 2xLeveraged Long Wells Fargo Business Development Company Index ETN (NYSEARCA:BDCL), the Monthly Pay 2xLeveraged Closed-End Fund ETN (NYSEARCA:CEFL) and the ETRACS 2xMonthly Leveraged Long Alerian MLP Infrastructure Index ETN (NYSEARCA:MLPL) compared to their hypothetical daily-reset counterparts. Only for the Monthly Pay 2xLeveraged Mortgage REIT ETN (NYSEARCA:MORL) was the daily-resetting analogue superior.
Monthly resetting of leverage can reduce decay but...
Ostensibly, the monthly reset feature of the ETRACS 2x ETNs is supposed to reduce their decay or "beta-slippage" under volatile conditions. For example, consider a scenario where a hypothetical index starts at level = 100 on day 0. On day 1 it increases by 10% to 110, and on day 2 it decreases by 9.09% to bring its level back to 100. It then remains at 100 the rest of the month. A daily-reset 2x leveraged fund will increase by 20% to 120 on day 1. It will then decrease by 18.18% (twice of 9.09%) on day 2 to match twice the daily return of the index. However, this brings its level not to 100, but to 98.18 instead. This has been termed decay or "beta-slippage", in various articles on this phenomenon.
Now consider what happens instead for a monthly-reset 2x leveraged fund. Because the index started at and finished at 100 for the month, the 2x fund will also remain at 100 because its performance is linked to twice the monthly return of the index. In other words, the monthly-reset feature has protected the 2x fund from leverage decay.
...hurts performance during sustained declines
As the example above showed, monthly-resetting can protect a leveraged fund from decay or beta-slippage when the underlying index is volatile but ends up with no net change. Of course, Investing 101 tells us that there is no free lunch. The downside of monthly-resetting is that it hurts performance when there is a sustained move in the downwards direction.
As I described in a recent article "Explaining The Action In MLPL", the announcement of the closure of MLPL appeared to trigger a number of unhappy comments regarding the performance of MLPL vis-a-vis the corresponding 1x fund, such as:
MLPL was down over 30% when AMLP, the fund it follows 2x, was down 7%. The whole purpose of UBS was being able to regulate. Hope there's a class action....I'm sure there will be.
In that article, I showed that this was due to the monthly reset feature of MLPL:
The answer to this discrepancy lies in the monthly reset feature of MLPL. Remember that the total return of MLPL is linked to twice the monthly return performance of the underlying index. As noted previously, MLPI's close of $18.37 on Jan. 20th represented a 28.3% decline from its monthly closing value of $25.62. Meanwhile, MLPL's monthly closing value was $21.11. In order for MLPL to match twice the monthly return of MLPI at the close of Jan. 20th, its value must decline by a total of 28.3% x 2 = 56.6% from the previous month, or to $9.16, at the of the day. Indeed, MLPL closed at $9.22 on Jan. 20th, which is within 1% of the above calculated value. Unfortunately, having to drop to $9.22 from the previous day's close of $11.41 represented an ugly -19.19% decline for the day, much more than twice that of MLPI's (-6.85%).
However, I do note that the above reader was not wrong in predicting that class action lawsuits would follow. It appears that at least one law firm is already investigating MLPL and the UBS ETRACS 2x Monthly Leveraged S&P MLP Index ETN (NYSEARCA:MLPV), which is also due to be mandatorily redeemed, for possible sales practice violations.
Zooming in on the price action
My previous article only looked at the price action of MLPL on Jan. 20th, the day that the closure was announced. In this article, I wish to take a deeper look at the price action of MLPL and the corresponding 1x fund, the ETRACS Alerian MLP Infrastructure Index ETN (NYSEARCA:MLPI), for the entire month.
The graph below shows that MLPL has been tracking approximately twice the total return of MLPI this month, as it should. So far, so good.
The next chart shows the total return of MLPI and MLPL for each day in January since the previous monthly close. Also shown is 2x the monthly return of MLPI ("MLPI x 2") as a comparison. We can see that at each date, the total return of MLPL since the previous month-end has indeed been approximately twice that of MLPI. This suggests that MLPL has been doing its job properly.
However, where it gets interesting is when we compare the daily returns of the two funds. The monthly-resetting feature of MLPL means that the daily returns of MLPL are not going to be necessarily twice those of MLPI.
I've added data labels to the final four days of the chart just to show how large the discrepancies can be. On Jan. 19th, the day before the acceleration event was triggered, MLPI declined by "only" -5.83% but MLPL dropped by a disproportionate -15.67%. The next day, MLPI decreased by a further -6.85% while MLPL cratered by -19.19%. As explained earlier, this is because MLPL is in a way "anchored" to the previous month's close such that its indicative value at any time must reflect twice the performance of the index since the previous month end.
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 can lead to a vicious cycle if the index keeps dropping, as we saw on the two days preceding and including the closure announcement. On the flip side, increases from that low level are also intensified. On Jan. 21st and 22nd, MLPI rallied by 5.61% and 9.12%, respectively, while MLPL experienced more than double the gains at 17.90% and 21.71%. (Note that my values may differ from those reported on Google or Yahoo Finance because I have utilized the indicative value of the funds from the ETRACS websites, which I consider to be more a reliable method because the closing prices displayed on financial aggregators may not always reflect the true value of a fund due to a lack of trades near market close or investors buying and selling the funds above or below their NAV).
A previous example
A similar phenomenon was observed in Sep. 2015, a month where MLPI dropped -15.3% and MLPL declined -29.9%. MLPI's low that month actually brought it to -22% compared to the previous month's end, and if the index had declined a further -8% that month, the mandatory acceleration event would have been triggered (due to the index falling by -30% in a month).
Again, the daily returns towards the end of the month reveal that the movements in MLPL were starting to become out of whack with what would have been expected for a 2x fund. On the penultimate day of the month, MLPI declined by "only" -6.21% while MLPL dropped -15.77%. The final day saw a reversal of fortunes, with MLPI gaining 8.59% and MLPL exploding for 22.99%. In both cases, the daily return for MLPL was much more than twice that of the underlying MLPI.
The fact that leveraged funds "decay" when the underlying index is volatile but with no net change in price is well-known. The ETRACS 2x leveraged ETNs launched by UBS have an interesting mechanism whereby their leverage resets monthly rather than daily. While this does protect against decay caused by day-to-day volatility, this article illustrates one drawback of this mechanism. That is, if the underlying index has already significantly declined in the month, any further changes in the index are magnified disproportionately (i.e. greater than 2x) in the monthly-resetting 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. Holders of MLPL (and also MLPV) can probably attest to both of those situations.
As always, there is no free lunch in investing, and investors in any of the ETRACS 2x leveraged ETNs should be aware of how this monthly resetting operates, including the possibility of disproportionate losses when things go south.
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.