Last month, disaster in the oil and gas markets caused the closure of two UBS (NYSE:UBS) ETRACS 2x leveraged ETNs, the ETRACS 2x Monthly Leveraged Long Alerian MLP Infrastructure ETN (formerly MLPL) and the ETRACS 2x Monthly Leveraged S&P MLP Index ETN (formerly MLPV). As discussed in "Explaining The Action In MLPL", the reason that the funds were mandatorily redeemed was that the underlying index, the Alerian MLP Infrastructure Index (which is also tracked by the unleveraged ETRACS Alerian MLP Infrastructure Index ETN (NYSEARCA:MLPI), declined by 30% in the month of January.
The last day of trading for MLPL appeared to be on Friday, Jan. 29th, and in its last few days of existence MLPL appeared to converge towards a fixed price. This is consistent with the acceleration amount being related to the volume weighted-average NAV closing price over the final several days, as noted by Seeking Alpha user vassk:
From what I understood, the unitholders will essentially receive the average of the final five NAV closing prices beginning last Thursday.
In this particular case, MLPL holders were rather unlucky. While MLPs rocketed higher over the last few days of the month, MLPL was unable to participate in this rally because its redemption value (which remember, is the average of the final five closing NAV prices) was weighed down by the lower prices that occurred in the days before.
However, despite MLPL holders getting the short end of the stick here, I don't think that there was any malicious intent on UBS' part. The index could have just as easily sunk over the last few days of January, in which case MLPL would have been somewhat protected because its redemption value would have been buoyed by the higher prices from the previous days.
Why would UBS implement such a redemption mechanism instead of just redeeming the notes at their "actual" indicative value (that is, the indicative value the notes would have traded at had acceleration not occurred)? My guess is that it gives them time to unwind their hedges as the fund nears its expiration date. Otherwise, they would have had to sell all of their hedges on the final trading day of MLPL, which depending on the size of the trades could cause the market to move against them unfavorable as they were unwinding. Of course, this is assuming that they were hedged in the first place, which I think is quite likely.
As Seeking Alpha user cubeless shrewdly noticed, MLPL has been recently reborn as the ETRACS 2xMonthly Leveraged Alerian MLP Infrastructure Index ETN Series B (NYSEARCA:MLPQ), which began trading on Feb. 8th, 2016. Similarly, MLPV has been resurrected as the ETRACS 2xMonthly Leveraged S&P MLP Index ETN Series B (NYSEARCA:MLPZ). This is good news for investors interested in obtaining leveraged exposure to MLPs, as after MLPL/MLPV had been redeemed, there were no longer any 2x (or higher) leveraged MLP funds on the market. To preempt any "leverage = bad" comments, I would like to direct you to my recent article which suggests that, crazily as it sounds, investing in MLPL could actually have protected your capital (compared to a leverage-adjusted equivalent investment in MLPI).
At first glance, MLPQ and MLPZ appear to be clones of their expired brethren, MLPL and MLPV, respectively, as they track their same underlying indices. As always, however, the devil is in the details, and studying the prospectuses of the two new funds reveals important changes that investors should be aware of.
In my previous article, I lamented the loss of MLPL because as one of UBS' earliest ETRACS ETNs, it had a very low expense ratio of 0.85% (excluding 3-month libor, which currently stands at 0.62%). After taking leverage into account, this made MLPL even cheaper than giants Alerian MLP ETF (NYSEARCA:AMLP) and JPMorgan Alerian ETN (NYSEARCA:AMJ), which both have expense ratios of 0.85% (excluding the tax expenses associated with AMLP).
Regretfully, UBS has continually increased the fees of its newer launches, as noted in "An Update On UBS's ETRACS 2X Leveraged ETNs". MLPV charged an egregious 1.95% in fees, which was actually composed of an innocuous-looking 0.95% "tracking rate" displayed on the fund website, together with a hidden-in-fine-print 1% "financing charge" that can be found on page 6 out of the 88-page Prospectus Supplement.
Will MLPQ uphold the low fees of its predecessor? Take a guess!
The answer is no. The following table compares the tracking rates and financing charges for the funds. Remember that MLPQ is the successor of MLPL, while MLPZ is the successor of MLPV.
|Tracking rate / %||0.85||0.95||0.85||0.95|
|Financing charge / %||0||1||0.80||1|
|Total expense ratio / %||0.85||1.95||1.65||1.95|
|Adjusted total expense ratio /%||0.425||0.975||0.825||0.975|
MLPZ has the same fee structure as MLPV, but sadly, MLPQ's total expense ratio is 0.80% higher than that of MLPL's due to its additional financing charge, which MLPL did not have. This makes the total expense ratio of MLPQ 1.65%. I've also shown an "adjusted" expense ratio in the final row of the table which is simply computed by dividing the total expense ratio of the fund by two. I consider that this is a useful metric that allows for comparison with unleveraged funds, because the 2x leverage of these ETNs means that you are controlling $2 worth of assets for every $1 invested in the fund. Keeping in mind that most MLP funds charge 0.85% or higher, MLPQ's adjusted expense ratio of 0.825% (excluding libor) can still be considered somewhat palatable, even though it is a disappointing increase from MLPL's old adjusted expense ratio of 0.425%.
Changed acceleration criteria
Perhaps as a result of the latest redemption event, UBS appears to have changed the mechanism for acceleration such that a -30% monthly decline in the index is no longer considered to be a criterion for redemption. In MLPL's prospectus, the passage under "Acceleration upon Minimum Indicative Value or Intraday Index Value" states (emphasis mine):
If, at any time, (1) the indicative value on any Index Business Day equals $5.00 or less or (2) the intraday index value on any Index Business Day decreases 30% from the most recent Monthly Initial Closing Level (each such day, an "Acceleration Date"), all issued and outstanding Securities will be automatically accelerated and mandatorily redeemed by UBS (even if the indicative value would later exceed $5.00 or the intraday index value would increase from the -30% level on such Acceleration Date or any subsequent Index Business Day) for a cash payment equal to the Acceleration Amount.
However, the corresponding section in MLPQ's prospectus is instead titled "Acceleration Upon Minimum Indicative Value" and reads:
If, at any time, the indicative value of the Securities on any Index Business Day equals $5.00 or less (the "Indicative Value Acceleration Trigger") (each such day, an "Acceleration Date"), all issued and outstanding Securities will be automatically accelerated and mandatorily redeemed by UBS (even if the indicative value would later exceed $5.00 on such Acceleration Date or any subsequent Index Business Day) for a cash payment equal to the Acceleration Amount.
Note that the newer fund MLPQ lacks a provision for acceleration when the index declines by 30% in a month.
Why has this change been made? Ostensibly, this would suggest that UBS is acknowledging the massive volatility in the MLP space that is currently going on, and wants to make harder for the funds to be mandatorily redeemed. To be honest, I don't really know why there was this criterion in the first place. I can't see how UBS massively benefits when the index declines by 30% and the notes have to be redeemed (assuming they are fully hedged). If anyone has any idea, please share with your fellow readers in the comments section below.
Without this provision, MLPQ and MLPZ should be less likely to be accelerated. I guess this benefits UBS because shutting and opening new funds do entail a significant administrative expense. That being said, why not also scrap the $5.00 minimum indicative value criterion that still remains for both funds? Again, I can't see what UBS stands to gain from including that provision for its funds. Please share if you have any suggestion as to what the intended purpose of this feature could be.
A new "Loss Rebalancing Event"
The most interesting of these changes is in the inclusion of a new "Loss Rebalancing Event" for MLPQ and MLPZ that were not found in either of the two old funds. This section of the prospectus reads:
A Loss Rebalancing Event will have the effect of deleveraging your Securities with the aim of resetting the then-current leverage to approximately 2.0. This means that after a Loss Rebalancing Event, a constant percentage increase in the Index Closing Level will have less of a positive effect on the value of your Securities relative to before the occurrence of the Loss Rebalancing Event.
A "Loss Rebalancing Event" occurs if, at any time, the Intraday Index Value on any Index Business Day (other than an Excluded Day, as defined herein) decreases 20% in value from the previous Monthly Initial Closing Level or Loss Rebalancing Closing Level, whichever is more recent. If a Loss Rebalancing Event occurs, the Current Principal Amount of the Securities will be reset as described below.
New Current Principal Amount = previous Current Principal Amount × Index Factor on the applicable Loss Rebalancing Valuation Date - Accrued Financing Charges on the applicable Loss Rebalancing Valuation Date
Like most of the content of the prospectus, the above just sounds like a bunch of mumbo-jumbo legalese. What does it mean?
Remember what I reported about the effect that the monthly-resetting feature of the ETRACS 2x ETNs has when the underlying index declines significantly? As explained in "ETRACS Monthly-Reset 2x Leveraged ETNs: Consistent Declines Are Magnified", well, consistent declines are magnified! Recall that on the days surrounding the announcement of the acceleration event, the price action for MLPL was becoming out of whack compared to what would have been expected for a 2x leveraged fund.
For example, MLPI declined by -5.83% and -6.85% on Jan. 19th and 20th, respectively, whereas MLPL crashed by -15.67% and -19.19%, much more than twice of the 1x fund. The following day, MLPI gained 5.61%, but MLPL rocketed ahead by 17.90%. What was happening was that because MLPL is required to track twice the monthly return of the underlying index, it became "anchored" to the previous month's index closing value such that any movements from its low point became magnified (i.e. by more than 2x).
In my previous article, I summarized this thusly:
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.
In other words, the "effective leverage" of the fund will increase beyond 2 when the index value has declined significantly in that month. (When the index rises significantly in a month, the opposite is true. As explained in "ETRACS Monthly-Reset 2x Leveraged ETNs: Consistent Gains Are Muted", the "effective leverage" of the 2x ETN will decrease to below 2 when this happens.)
How does the new "Loss Rebalancing Event" affect the status quo? This event is triggered when the underlying index has declined by 20%. When this happens, the 2x fund will switch from tracking twice the total return of the index since the previous monthly close to tracking twice the total of the index since the "Loss Rebalancing Valuation Date", which is simply the day after the Loss Rebalancing Event is triggered. In other words, this will act to reduce the leverage of the fund back to 2.
Is this a good or bad change? While the above statement from the prospectus appropriately identifies the risk, that is, following the Loss Rebalancing Event "a constant percentage increase in the Index Closing Level will have less of a positive effect on the value of your Securities relative to before the occurrence of the Loss Rebalancing Event", it does omit the potential benefit of this change. That is, any further declines in the index will be relatively mitigated compared to if the Loss Rebalancing Event had not occurred. What this means is that the volatility in the new 2x ETNs should be reduced as compared to what happened with MLPL and MLPV when the index declines significantly during the month.
Note that a Loss Rebalancing Event can be triggered multiple times during a single calendar month. This can happen if the index declines 20% from its value on the most recent Loss Rebalancing Valuation Date.
Summary and perspective
MLPL and MLPV have been reborn as MLPQ and MLPZ, respectively. Interestingly, a number of changes have been made to the new ETNs compared to the old funds:
- MLPQ charges 0.80% higher fees compared to MLPL, whereas MLPZ and MLPV have the same (high) fee structure.
- Unlike the older funds, MLPQ and MLPZ will not be subject to acceleration if the index declines by 30% in a calendar month.
- A new "Loss Rebalancing Event" will be triggered if the index declines by 20% in a calendar month. This acts to reduce the leverage back to 2, which would decrease volatility going forward compared to what would have happened for the older funds.
While I have no way of knowing whether UBS read my articles, I do take pleasure in acknowledging the efforts that my fellow readers and myself have undertaken in order to uncover unusual behavior in popular vehicles like the ETRACS 2x ETNs. Moreover, I do note that, to the best of my knowledge, the explanation for the crazy price action of MLPL last month was not presented anywhere else on the interwebs except for in my articles on Seeking Alpha. Hopefully, drawing attention to such issues could induce fund issuers to take note and effect changes, as may have been the case here, and possibly also for the ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN (NYSEARCA:CEFL) for which the rebalancing mechanism was recently changed to prevent the frontrunning of the index that I had previously identified to be highly deleterious to CEFL holders. Again, that analysis appeared to be exclusive to Seeking Alpha, and is also something that I couldn't have done without input from numerous readers, many of whom are much more experienced than myself.
Maybe, one day UBS will heed my many admonishments regarding the ever-increasing fees of their ETRACS line-up, and actually go and lower them. But I probably shouldn't hold my breath.
Disclosure: I am/we are long MLPQ.
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.