Excessive Dividends: Leveraged ETNs For The Average Joe

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Includes: BDCL, CEFL, DVHL, LBDC, LMLP, MORL, MRRL, SMHD
by: Scott Nickerson

Summary

The leveraged ETN distribution paying world is smaller than you think.

Introducing the Leverage for the Average Joe Portfolios.

It's all about the payouts.

A couple of years ago I wrote an article titled "Double the Fun or Double the Trouble?". In it, I discussed the relative merits and pitfalls of using a leveraged ETN, the UBS ETRACS Monthly Pay 2X Leveraged Dow Jones Select Dividend Index ETN (NYSEARCA: DVYL) versus the non-leveraged iShares (BlackRock) Select Dividend ETF (NYSEARCA: DVY) fears and have utilized the leveraged ETNs to better the dividend payments of my holdings.

As I pointed out in my article, some of the risks of ETNs are unique to this form of investment. But, as we all know, there are risks associated with any investment. It appears many people have overcome this fear as well. In fact, the Leveraged investment world has grown substantially and continues to add to the diversity and availability of its options.

How do you navigate the mine field of leveraged ETNs as a dividend investor? Fortunately, it is fairly simple. Even though there are multiple sources for ETNs and leveraged investment products, (Scottrade lists 191 different ETNs available offered by ten different fund families) there are only 57 leveraged ETNs. Of those 57 leveraged products, only 16 pay dividends, narrowing the field of possibilities for dividend investors such as myself considerably.

Narrowing the list even further is also an easy decision. UBS offers 14 of those 16 with Credit Suisse offering the remaining two. I eliminated the two Credit Suisse offerings as they have not been trading for a full year yet. Eight of the UBS offerings have a trailing twelve month yield in excess of 10%. That's where I started my list below.

Name

Symbol

TTM Yield

Initial Trade Date

Approx. Net Assets

Expense Rate

UBS ETRACS 2x Leveraged Long Wells Fargo Business Development Company Index ETN

(NYSEARCA:BDCL)

13.5%

5/24/11

$260 million

0.85%

UBS ETRACS Monthly Pay 2x Leveraged Mortgage REIT ETN

(NYSEARCA:MORL)

19.6%

10/16/12

$290 million

0.40%

UBS ETRACS Monthly Pay 2x Leveraged Diversified High Income ETN

(NYSEARCA:DVHL)

12.1%

11/12/13

$19 million

0.85%

UBS ETRACS Monthly Pay 2x Leveraged Closed-End Fund ETN

(NYSEARCA:CEFL)

18.1%

12/10/13

$240 million

0.50%

UBS ETRACS Monthly Pay 2x Leveraged Wells Fargo MLP ex-Energy ETN

(NYSEARCA:LMLP)

10.1%

6/24/14

$24 million

0.85%

UBS ETRACS Monthly Pay 2x U.S. Small Cap High Dividend ETN

(NYSEARCA:SMHD)

12.0%

2/3/15

$27 million

0.85%

UBS ETRACS 2x Leveraged Long Wells Fargo Business Development Company Index ETN

(NYSEMKT:LBDC)

13.5%

10/9/15

$20 million

0.85%

UBS Etracs Monthly Pay 2x Leveraged Mortgage REIT ETN Series B

(NYSEARCA:MRRL)

19.6%

10/9/15

$15 million

0.40%

Those familiar with dividend investing on this site have surely thought about putting a toe in the water with these extreme distribution yields. Reviewing the chart, it is easy to get distracted by the yields but the larger picture is enhanced by the differences in net asset value. MORL, CEFL and BDCL all sport net assets ten times larger than the rest of the list. This trio shows up in Professor Brofman's articles as the three legged stool of high yielding leveraged ETNs. If you haven't caught any of his articles, I highly recommend them.

Notes on Holdings and the Indexes

Of the three notes, CEFL spreads its investment dollars more evenly than the other two. Investing in 30 closed end funds, the top fifteen funds have a current position (as of 2/20) between 4.04% and 4.43%. CEFL tracks a 2X position of the ISE High Income Index. This is the same index used by the YieldShares High Income ETF (NYSEARCA:YYY), which offers a monthly $0.16 distribution ($1.92 annually, current yield 10.05% yield).

BDCL tracks 2x the Wells Fargo Business Development Company Index. UBS offers a 1x ETN product that tracks the same index, BDCS, as well as Series B ETNs of both (tickers: BDCZ and LBDC). For BDCL, 5 of the 42 tracked BDCs represent 48% of the note, putting nearly half of its value on these five companies. The five companies all sport market caps in excess of $1 billion so there's a little comfort there. They are (in alphabetical order by ticker) AINV (Apollo Investment Corp), ARCC (Ares Capital Corp), FSIC (FS Investment Corp), MAIN (Main Street Capital Corp) and PSEC (Prospect Capital Corp). The VanEck Vector Business Development Company Income ETF (NYSEARCA:BIZD) holds 24 of the 42 with 4 of the top 5 the same companies, albeit different but similarly high concentrations.

MORL tracks 2X the MVIS Global Mortgage REIT Total Return Index. This index is tracked by a UBS ETRACS Series B 2X ETN (NYSEARCA:MRRL) and a 1X ETF, the VanEck Vector Mortgage REIT Income ETF (NYSEARCA:MORT). MORT offers a current TTM yield of 8.11% with variable distributions quarterly. Like its BDC counterpart, MORL has a concentration of its investment in a few companies with the top 6 of its 24 holdings taking up 47.93%.

Investment Setup

With no direct overlap on the investments, the three notes collectively form a solid cross financial investment. To present the merits of this investment, I utilized the same methods of share balancing put forth in my article Creating Wealth For The Average Joe - An Investment Plan And Model Portfolio. In that article I set up the basic rules for an investment model which I followed in the development of this Leveraged Investment Portfolio: Leverage for the Average Joe. The model is based on small incremental weekly capital infusions that the Average Joe can afford and slowly increases the weekly amount year after year to not disrupt any budget.

The rule highlights:

This is a Buy and Hold/ dollar cost Averaging plan with all dividends/distributions reinvested. This plan uses "real world data and expenses are included ($7.00 per transaction) Initial investment is $500.00 Weekly capital infusion is $5.00 per week for the first year, moving up $1.00 per week the next year and for the first five years. The next five year period increments by $2.00 per year, then $4.00, then $6.00, etc. Investing in a product is initialized after the product has been on the market for a minimum of six months at the beginning of a quarter. A new portfolio is started every year. Initial purchase is however many shares can be afforded from available funds. Subsequent purchases are 1 share one time, two shares two times, 4 shares 4 times, 8 shares 8 times, etc. Purchase rotate through the portfolio beginning with the oldest available product. New holdings "jump the line" for their initial purchase when they become available. Real world ex-dividend dates and pay dates are utilized.

I'll Call this series of Portfolios: Leverage for the Average Joe.

Establishing a start date: BDCL passed its six month mark in late 2011 so the first portfolio starts in Jan of 2012. All data used in these tables is as of close on 2/17/17. The positions of each yearly start portfolio are shown in the table below.

Portfolio Start

BDCL

MORL

CEFL

2012

127

31

21

2013

71

30

20

2014

39

31

18

2015

24

24

20

2016

20

20

16

2017

9

9

8

The holdings and cash positions for each of the portfolios is shown in the table below.

Portfolio Start

Holdings

Cash Position

Total Portfolio

2012

$ 3542.29

$ 14.04

$ 3556.33

2013

$ 2329.36

$ 21.92

$ 2351.28

2014

$ 1637.11

$107.56

$ 1744.67

2015

$ 1241.92

$ 64.33

$ 1306.25

2016

$ 1023.40

$ 3.23

$ 1026.63

2017

$ 491.67

$ 26.00

$ 517.67

The distributions, capital input (through week of 2/13) and expenses incurred for each of the portfolios is shown in the table below.

Portfolio Start

Distributions Rec'd

Capital Input

Expenses

2012

$1407.32

$2402.00

$ 238.00

2013

$ 770.94

$1915.00

$ 196.00

2014

$ 519.59

$1492.00

$ 168.00

2015

$ 299.76

$1121.00

$ 140.00

2016

$ 156.41

$ 802.00

$ 98.00

2017

$ 16.26

$ 535.00

$ 42.00

So those of you who can do the quick math realize that these portfolios are under water from a total return standpoint. Taking distributions received and adding in capital input less current cash on hand gives us the total dollars invested. Subtracting current holdings value gives us the total return. Let's put this into prospective in the table below.

Portfolio Start

$ Invested

CV

Total Return

2012

$3795.28

$3542.29

($252.99)

2013

$2664.02

$2329.36

($334.66)

2014

$1904.03

$1637.11

($266.92)

2015

$1346.53

$1241.92

($113.51)

2016

$ 955.18

$1023.40

$ 68.22

2017

$ 525.26

$ 491.67

($ 33.59)

This is a perfect example while real world scenarios are so important. The financial reporting world tends to over simplify any investment and highlight the good (15.33% current yield) when in reality the total return is negative.

So why would anyone want to continue down this path? Distributions. You could stop the capital input and invest solely with the distributions and still grow the portfolios with the substantial yields. In Q4 of 2016, the 2012 portfolio start received $121.94 in distributions. I expect Q1 to exceed that. That leaves approximately two quarters from a breakeven on total return.

Speaking of yields. I'd be remiss if I didn't point out the positive. Yields are shown in the table below: Current yield (Latest qtr x 4/ current price), Yield on cost (Latest qtr x 4/total cost), Trailing twelve month yield, (Distributions received over the last twelve months/ current price)

Portfolio Start

Current Yld

YOC

TTM Yld

2012

15.33%

12.80%

12.94%

2013

15.33%

9.99%

12.74%

2014

15.98%

11.02%

13.50%

2015

16.20%

11.32%

13.22%

2016

16.22%

12.97%

13.58%

2017

N/A

N/A

N/A

Comparing to the Broad Market Indexes

In another series of articles I write, I utilize the same methodology to buy and hold ETFs representing the S&P 500, Dow Jones Industrial Average and the Nasdaq 100, collectively the broad market indexes. Comparing the same year portfolios, the UBS "Big 3" fares slightly better, with an average edge of $33.03 over the Broad Market Portfolios.

Portfolio Start

UBS "Big 3"

Broad Market Portfolios

Difference

2012

$ 3556.33

$3325.12

$231.21

2013

$ 2351.28

$2492.25

($140.97)

2014

$ 1744.67

$1766.72

($ 22.05)

2015

$ 1306.25

$1268.37

$ 37.88

2016

$ 1026.63

$ 915.41

$111.22

2017

$ 517.67

$ 536.76

($ 19.09)

Having a lengthier history on the Broad Market Portfolios, which go back to the turn of the century, gives us a better prospective on long term outcomes. Adding in earlier BMP starts into the same chart and we see a better projection of where the UBS "Big 3" could go.

Portfolio Start

UBS "Big 3"

Broad Market Portfolios

Difference

2000

N/A

$35970.86

N/A

2001

N/A

$31307.68

N/A

2002

N/A

$26339.12

N/A

2003

N/A

$23286.88

N/A

2004

N/A

$18569.73

N/A

2005

N/A

$15407.05

N/A

2006

N/A

$12580.25

N/A

2007

N/A

$10397.60

N/A

2008

N/A

$ 8633.61

N/A

2009

N/A

$ 7410.71

N/A

2010

N/A

$ 5603.16

N/A

2011

N/A

$ 4347.07

N/A

2012

$ 3556.33

$ 3325.12

$231.21

2013

$ 2351.28

$ 2492.25

($140.97)

2014

$ 1744.67

$ 1766.72

($ 22.05)

2015

$ 1306.25

$ 1268.37

$ 37.88

2016

$ 1026.63

$ 915.41

$111.22

2017

$ 517.67

$ 536.76

($ 19.09)

Besides the obvious market fluctuation, two other factors enter into this comparison. Expenses on the BMP are greatly reduced due to the price per share of the three ETFs versus the considerably lower prices of the UBS ETNs; i.e., more ETN note purchases and transactions will be bought over the same timeframe, incurring larger expenses.

Portfolio Start

Ttl Expenses UBS Big 3

Ttl Expenses BMP

2012

$ 238.00

$79.00

2013

$ 196.00

$63.00

2014

$ 168.00

$49.00

2015

$ 140.00

$42.00

2016

$ 98.00

$28.00

2017

$ 42.00

$14.00

The second factor is the disparity on the yields. Trailing twelve month yields on the BMPs average 1.60% while the TTM on the ETNs is 13.20%. That is 8.25 times higher. Again, looking at the history of the BMP we find early year starts, as one would expect, at a significantly higher payout rate. The 2000 start BMP received $165.62 in dividends in Q4 of 2016. A mature ETN portfolio could produce 8.25 times that or somewhere in excess of $1300 in a quarter. That's additional income into the fund of $100 per week. Simply put, I'm going to let this dog hunt a while longer to see if the longevity factors turn these portfolios positive and quickly build. Updates will follow.

Disclosure: I am/we are long MORL, CEFL, BDCL, SMHD.

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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