As most readers know, the UBS ETRACS Monthly Pay 2xLeveraged Closed - End Fund ETN (NYSEARCA:CEFL) is a leveraged fund linked to the ISE High Income Index which contains 30 closed-end funds. In this article we look at diversification benefits of holding the Index over any one of the individual funds. In other words, does the investor in CEFL benefit from any portfolio effects of holding these funds and if so, how much?
Split by Asset Type
The first and most basic analysis we can do is to look at the Asset Composition of the CEFL portfolio.
We look at the declared Asset Class focus of each fund and sum up the allocations. In the chart to the right we can see that Fixed Income is the primary asset class with a 64% allocation, followed by Equities with 29% and a group called "Mixed Allocation" which mostly straddles the two main assets classes.
Digging into the actual fund holdings we can see the following types of assets:
- Equities and Preferreds
- Covered Calls
- Treasuries and Munis
- EM Bonds (USD and Local Currency)
- MBS, ABS and CDOs
- Leveraged Loans
Fund yield is one of the three key metrics used in determining the constituent fund allocation in the ISE High Income Index (the Index rebalances annually) so it's not surprising to find a high allocation to Fixed Income assets which can typically generate higher income than Equity-linked funds.
Range of Returns
The second type of analysis we can do gauge the diversification benefits of holding CEFL over the average constituent fund is to look at the actual paths of each fund since the last rebalancing of the Index at the end of last year.
The thick blue line in the chart below is YLDA (the ticker used for the Index) while the gray lines are each of the 30 constituent funds. The line zooming off the top of the chart is the GAMCO Global Gold, Natural Resources & Income Trust (NYSEMKT:GGN) which has performed incredibly well due to the recovery in the oil price and the rally in gold.
What stands out in this chart is the middle-of-the-road path that YLDA has taken over the last year, clearly benefiting from the diversification benefits of holding the entire portfolio of funds, while, of course, giving up the upside return benefits of clairvoyance of having picked .
Volatility and Drawdowns
A third type of analysis we can do to gauge the diversification benefits of CEFL is to look at the price volatility of the constituent funds over the volatility of YLDA and CEFL.
The chart on the left shows the allocation-weighted price volatility (1-month and 1-year) of the average constituent fund and the price volatility of YLDA itself. As expected, YLDA exhibits significantly lower price volatility - by 28%. CEFL also benefits from lower volatility from 2x the allocation-weighted price volatility of the constituent funds by 20%. The benefit is lower mostly due to the trading dynamics of CEFL and the noise in its premium/discount to NAV.
In terms of maximum drawdowns - the maximum constituent drawdown this year was almost 19% in the Alpine Global Premier Properties Fund (NYSE:AWP) while YLDA suffered only a 9% drawdown.
Constituent Realized Correlation
Finally, we look at the average pairwise constituent correlation. A high correlation number would indicate that the constituent funds tend to trade in line while a low correlation would indicate that the individual performances are much more dispersed. The actual realized correlation of the funds (as measured on a 3-month running basis) has been between 40 and 80%. In our view, this is quite healthy.
The metrics above all argue that YLDA or the ISE High Income Index does provide significant diversification benefits over the average constituent fund. Whether this is sufficient for the risk embedded in CEFL we will leave to the individual investor. And while the metrics above look quite robust to us, we must caution holders of CEFL to keep an eye on the Equity / Interest Rate correlations which have been rising (see chart below). If Bonds and Equities start moving together (such as during periods of sharp interest rate moves higher like the Taper and Bund Tantrums of 2013 and 2015) then the diversification benefits described above may be more limited. Although this risk is tempered by the fact that YLDA constituent funds hold "risky" rather than "risk-free" bonds, some risk still remains.
Our cautious investment thesis on CEFL remains in place. On the valuation front both Equities and Bonds remains expensive. Interest rates have begun moving higher and a disorderly readjustment may prove painful for CEFL longs. The earnings season will most likely prove disappointing given high expectations and the next few months will provide a busy docket of Risk events: the U.S. elections in November, the Fed in December as well as ongoing uncertainty with Brexit, ECB QE and the Italy Referendum next year.
For now, Good Luck!
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.