ETRACS 2x Leveraged ETN Snapshot, January 2018: Brief Notes On LMLP And Annual Distribution Growth Rates Updated

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Includes: AMLP, ARCC, BDCL, BDCS, CEFL, DVHL, DVYL, HDLV, HOML, IMLP, LBDC, LMLP, LRET, MAIN, MLPI, MLPQ, MLPZ, MORL, MORT, MRRL, PEX, PSP, SDYL, SMHD, SPLX, YYY
by: Stanford Chemist

Summary

MORL/MRRL are the highest-yielding 2x ETNs, followed by BDCL/LBDC.

3-month LIBOR jumped up by 13 bps this month, pushing expense ratios higher.

Brief notes on LMLP, and annual distribution growth rates updated.

For the inaugural edition of the ETRACS 2x Leveraged ETN Snapshot, please see here. Data are taken from the close of Jan. 15, 2018. Previous articles on the Snapshot can be searched using the keyword "client."

Fund additions, closures, or notable adjustments

No new ETRACS 2x fund additions or closures.

The funds

The following table shows the ETNs in the ETRACS 2x leveraged line-up, with the fund name, ticker inception date, assets under management, average volume, yield, expense ratio excluding 3-month LIBOR, adjusted total expense ratio including LIBOR, and the corresponding 1x fund (where available). Yield and expense ratio statistics are discussed further in their separate sections below.

Fund Ticker Inception Assets / m Volume / k Yield TER Adjusted TER 1x fund
Equity
Monthly Reset 2xLeveraged S&P 500 Total Return ETN (SPLX) 3/2014 4.6 1.1 0.00% 1.25% 1.48% (SPY)
Monthly Pay 2xLeveraged S&P Dividend ETN (SDYL) 5/2012 16.6 2.0 4.55% 0.70% 1.20% (SDY)
Monthly Pay 2xLeveraged Dow Jones Select Dividend Index ETN (DVYL) 5/2012 39.8 3.9 6.32% 0.75% 1.23% (DVY)
Monthly Pay 2xLeveraged US High Dividend Low Volatility ETN (HDLV) 9/2014 20.1 5.4 10.01% 1.45% 1.58%
Monthly Pay 2xLeveraged US Small Cap High Dividend ETN (SMHD) 3/2015 44.9 31.5 18.24% 1.65% 1.68%
Monthly Reset 2xLeveraged ISE Exclusively Homebuilders ETN (HOML) 3/2015 5.5 2.9 0.00% 1.65% 1.68%
Alternative equity
Monthly Pay 2xLeveraged Wells Fargo MLP Ex-Energy ETN (LMLP) 6/2014 31.8 18.5 11.97% 1.45% 1.58%
Monthly Pay 2xLeveraged MSCI US REIT Index ETN (LRET) 5/2015 4.8 3.0 8.05% 1.65% 1.68% (VNQ)
Monthly Pay 2xLeveraged Mortgage REIT ETN (MORL) 10/2012 441.4 259.3 18.91% 0.80% 1.25% (MORT)
Monthly Pay 2xLeveraged Mortgage REIT ETN Series B (MRRL) 10/2015 10.5 7.6 18.91% 0.80% 1.25% (MORT)
2xMonthly Leveraged Alerian MLP Infrastructure Index ETN Series B (MLPQ) 2/2016 61.0 17.6 17.49% 1.65% 1.68% (MLPI) (AMLP)
2xMonthly Leveraged S&P MLP Index ETN Series B (MLPZ) 2/2016 63.9 1.0 16.01% 1.95% 1.83% (IMLP)
2xLeveraged Long Wells Fargo Business Development Company Index ETN (BDCL) 5/2011 261.6 152.0 18.70% 0.85% 1.28% (BDCS)
2xLeveraged Long Wells Fargo Business Development Company Index ETN Series B (LBDC) 10/2015 7.8 1.4 18.70% 0.85% 1.28% (BDCS)
Balanced
Monthly Pay 2xLeveraged Closed-End Fund ETN (CEFL) 12/2013 280.5 169.1 15.72% 0.90% 1.30% (YYY)
Monthly Pay 2xLeveraged Diversified High Income ETN (DVHL) 11/2013 23.5 16.1 14.65% 1.25% 1.48%

*Excludes 3-month libor (currently 1.70%). (Source: Stanford Chemist, Morningstar)

Assets and volume

The chart below shows the assets under management and the average volume for all of the 2x ETNs. We can see that MORL is still the largest of the 2x ETNs, followed by CEFL and BDCL. MORL, CEFL and BDCL are also the three most actively traded ETNs.

(Source: Stanford Chemist, Morningstar)

Note that several of the ETNs are thinly traded. For those illiquid ETNs, it is recommended to use limit orders to ensure that the transaction is executed at an acceptable price. Moreover, it is highly recommended to check the indicative price of an ETN, available on the UBS ETRACS website (e.g., here for CEFL), before buying or selling the low-volume ETNs. This is because financial websites or brokers often quote the last-traded price, which can deviate significantly from the NAV (technically, "indicative value" for the ETNs) for the thinly traded ETNs.

Yields

One of the major attractions of the 2x leveraged ETNs is their often mouthwatering high yields. The yields (trailing 12 months) of the funds are displayed graphically below, arranged in order of smallest to largest. Note that SPLX and HOMX are total return funds, and hence pay zero distributions. MORL/MRRL lead with 18.9% yield, followed by BDCL/LBDC at 18.7% and SMHD at 18.2%. All of the ETNs pay monthly except for BDCL/LBDC, MLPQ and MLPZ, which pay quarterly (and except for SPLX and HOMX which pay no distributions at all).

(Source: Stanford Chemist, Morningstar)

Dividend growth rate (updated for 2018)

Investors might be interested in whether or not the 2x ETNs have been able to grow their distributions. The following chart shows the 1-year DGR and 3-year (annualized) DGR for the 2x ETNs, where available. Note that these are calendar year DGRs and therefore only show data where full years are available, for example, the 1-year DGR represents the distribution increase from 2016 to 2017, while the 3-year DGR represents the distribution increase from 2014 to 2017.

With another year under our belt, four more 2x ETNs that were incepted during 2015 now have two full calendar years (2016 and 2017) of distribution history: SMHD, LRET, LBDC and MRRL. HOML was also incepted in 2015, but since it is a total return ETN, distribution growth rate is not applicable.

We can see from the data below that 11 out of 12 leveraged ETNs for which data have been available have managed to increase their distributions from 2016 to 2017. LMLP showed the largest 1-year DGR increase (+32%), followed by SMHD (+26%) and DVYL (+20%). The only 2x ETN that decreased their distribution in 2017 was CEFL, which reduced payout by -12% (as predicted at the start of 2017 in "CEFL/YYY Investors Face Imminent 12% Distribution Cut").

In terms of 3-year DGR (from 2014 to 2017), data are now available for CEFL and DVHL, as both were incepted during 2013. Here, SDYL and DVHL have the highest 3-year DGRs of +15% and +10% respectively. CEFL had the lowest 3-year DGR of -16%, while DVHL, BDCL and MORL also had negative 3-year DGR numbers.

(Source: Stanford Chemist, Morningstar)

It should be remembered that the distributions of the 2x ETNs are not only affected by the yield of the underlying holdings, but also changes in price of the ETNs. This is because the ETNs are 2x leveraged. Hence, increases in the price of the ETNs will boost their distributions, and vice versa.

Expense ratios

Regarding the expense ratios, UBS engages in the (rather dubious, in my opinion) practice of hiding their financing spread within their pricing supplement, which makes their headline management fee (known as "tracking rate") look lower. For example, SDYL has an annual tracking rate of 0.30%, a figure that is displayed prominently on the fund's website, but you have to dig into the pricing supplement to see that you are being charged an additional 0.40% in financing spread. This means that the total financing rate will be 0.40% + 3-month LIBOR (currently 1.70%). Adding all three fees together gives a total expense ratio [TER] of 0.30% (tracking rate) + 0.40% (financing spread) + 1.70% (3-month LIBOR) = 2.40%.

However, remember that these ETNs are 2x leveraged. Thus, I devised an "adjusted TER" that takes into account both the current LIBOR rate, and the leverage of the fund, which can be achieved by simply dividing the total expense ratio (including LIBOR) by 2. I believe that this value is more useful when one is trying to compare the expense ratio of the 2x ETNs versus unleveraged funds. In fact, with some of the adjusted TERs being lower than the expense ratios for unleveraged 1x funds, it might be able to juice your portfolio by up to nearly 1% a year by synthetically replicating a 1x position (as described in "Build Your Own Leveraged ETF (ETRACS Edition)").

The following chart shows the expense ratio (excluding LIBOR) and the adjusted TER of the funds, arranged from lowest to highest. MLPZ has the highest expense ratio (excluding LIBOR) of 1.95%, and its adjusted TER comes out to 1.83%. SDYL has the lowest expense ratio (excluding LIBOR) of 0.70%, and its adjusted TER comes out to 1.20%.

(Source: Stanford Chemist, Morningstar)

The 3-month LIBOR rate has jumped up by another 13 basis points this past month, continuing to push ETN expense ratios higher.

Chart

3-Month LIBOR based on US Dollar data by YCharts

Position within 52-week trading range

I also calculated the position of the stock price of each 2x ETN as a function of their 52-week trading range which is a metric I have found to be quite useful when making buy or sell decisions. As a value investor, I am more inclined to buy a stock when its price is close to its 52-week low. Conversely, I am reluctant to buy stocks when their prices are close to their 52-week highs (of course, momentum investors will disagree).

In the below chart, 0% on the x-axis indicates the midpoint of the 52-week trading range. The -50% position indicates the 52-week low while +50% indicates the 52-week high. Note that some of these values may be inaccurate due to the low liquidity of some of the ETNs.

(Source: Stanford Chemist, Morningstar)

The past month has been a mixed bag in terms of performance. Interest rate sensitive funds such as LRET and MORL/MRRL have dropped significantly within their 52-week trading range, while the MLP funds MLPQ and MLPZ have recovered sharply higher. Equity funds such as SPLX, LMLP, SDYL, DVYL and HOML continue to trade close to the upper bound of their trading range, with LMLP showing particularly strong recent price action.

Performance

The following chart shows the recent performance of the suite of 2x ETNs, in terms of total return [TR]. 1-year, 3-year and 5-year TR values are given were available, with time periods longer than 1 year being annualized.

We can see from the chart above that most of the 2x ETNs have generally had strong 1-year TR performances. In particular, HOML (+185%) (near triple bagger in a year!) and LMLP (+60%) have both bested SPLX (+49%), the 2x version of the S&P 500. The two MLP funds, MLPQ and MLPQ, and BDCL/LDBC have been laggards over the past year, with total returns of between -4% and -7%.

Reminder about Series B ETNs

In October 2015, UBS launched six new "Series B" ETNs, four of which were 2x leveraged (MLPQ, MLPZ, MRRL, LBDC). The main difference between the original "Series A" ETNs and the Series B ETNs is that the former are co-guaranteed by both UBS AG and UBS Switzerland AG, whereas the newer the latter are guaranteed by UBS AG only. In theory, this should make the Series B ETNs less valuable than the Series A, since the former are solely guaranteed by UBS AG. However, it is hard to imagine a scenario where UBS AG goes under and its subsidiary, UBS Switzerland AG (and by extension the Series A notes) remains unscathed.

In the same announcement, UBS also stated that they do not intend to issue any new notes in any of its existing Series A ETNs. While this could in theory make those ETNs "broken products," a few simple guidelines could help prevent investors from going astray. First, this "does not affect the terms of the outstanding Series A ETRACS ETNs ... including the right of noteholders to require UBS AG to redeem their notes on the terms," meaning that if the ETNs were to deviate significantly below their NAV, large players could buy the notes on the open market and have UBS redeem them (the minimum number of shares for redemption is 50,000) at their NAV. This arbitrage potential should act as a driving force to push the price of the ETN back up towards its NAV.

On the other hand, if the notes were to deviate significantly above their NAV (say >10%), then what are you waiting for? Sell the notes right now on the open market and buy them back later when the price falls back to its NAV. This also serves to remind that one should always check the indicative value of the ETNs on the UBS ETRACS website before buying any fund. To my knowledge, despite UBS announcing suspension of issuance of new Series A ETN shares, none of the ETNs have ever traded significantly above (>10% ) their NAV for any sustained period time.

Reminder on leverage

An interesting feature of the ETRACS 2x leveraged ETNs is that their leverage resets monthly rather than daily, which is the norm for most leveraged funds in the market. It is well known that decay or slippage in leveraged funds will occur when the underlying index is volatile with no net change over a period of time. By resetting monthly rather than daily, the decay of the ETRACS ETNs might be somewhat mitigated.

Seeking Alpha author Dane Van Domelen has conducted both theoretical and empirical research into the performance of leveraged funds. His research showed that in most cases, the decay is not as serious as is often initially thought to be. My own research on the live performance of the 2x ETNs showed that monthly resetting has generally helped rather than hurt performance.

Moreover, the 2x ETNs charge a finance cost (3-month LIBOR plus a variable financing spread) to maintain their 2x leverage. Due to prevailing low interest rates, the finance charge is currently relatively low, but this could change when/if interest rates rise in the future. Still, the financing rates charged to these ETNs are still much lower than what the majority of retail investors would be able to access from their brokers. This means that from an expense ratio point of view, it would usually be better to buy the leveraged fund than to try and replicate it yourself with a margin loan from your broker.

Reminder on ETN structure

It should be noted that investors in the 2x ETNs are subject to credit risk from the fund sponsor, in this case UBS. If UBS were to go bankrupt, the ETNs will likely become worthless. Professor Lance Brofman has argued that the risk of ETN investors losing money due to UBS going bankrupt is, barring an overnight collapse, minimal because the notes can always be redeemed (the minimum number of shares for redemption is 50,000) at NAV.

Moreover, since ETNs are debt instruments, their distributions are considered as coupon payments rather than as dividends. Distributions from ETNs are therefore treated as interest tax-wise and subjected to the ordinary income tax rate.

Quick commentary

(This is normally exclusive to members of the Cambridge Income Laboratory, but is released to public as part of our free trial promotion.)

With LIBOR higher again this month by 13 bps (and about 40 bps over the last 4 months), much of what I wrote in last month's commentary appears to be still pertinent, and I'd encourage you to read it if you haven't done so already.

I'd like to take a quick look at LMLP in this month's commentary, which has been a strong performer over the past 1 year time frame. LMLP tracks twice the Wells Fargo Master Limited Partnership Ex-Energy Index, which is a market capitalization-weighted index of non-energy MLPs trading on the U.S. exchanges. There is a 10% weighting cap on any individual holding, which explains why many of the constituents of LMLP have about the same weight in the index. The top 10 names make up a whopping 91.01% of the index, making it even more concentrated than HDLV.

(Source: ETRACS UBS)

LMLP has a trailing TTM yield of 11.97%, paid monthly, and grew its distribution in 2017 by 32% compared to in 2016. The following chart shows the distribution history of the note since inception. Note lumpiness of distribution payments over the recent two months which has followed the pattern of one "big" month followed by two "small" months, much like MORL/MRRL and to a lesser extent CEFL.

(Source: Stanford Chemist, NASDAQ)

Even after accounting for its 2x leverage, LMLP (+63.40%) has done much better over the past year than two private equity ETFs, PowerShares Global Listed Private Equity Portfolio (NYSEARCA:PSP) (+27.22%) and ProShares Global Listed Private Equity ETF (PEX) (+16.40%).

Chart

LMLP Total Return Price data by YCharts

The reason for LMLP's outperformance is probably because of the different nature of its holdings versus PSP and PEX. LMLP's index is restricted to own MLP units and nothing else, while there is no such restriction for the two ETFs. Moreover, both ETFs are global funds, with only 36.78% and 43.95% in U.S. companies for PSP and PEX, respectively, while LMLP contains only domestic names.

As a result, both PSP and PEX's top lists may contain some not-quite-familiar names. We also see that PSP and PEX both include companies structured as BDCs, including Ares Capital Corporation (ARCC) and Main street Capital Corporation (MAIN).

(Source: ETFDB)

Since inception of LMLP in June 2014, however, its performance has lagged the two ETFs.

Chart

LMLP Total Return Price data by YCharts

Part of this can be blamed on a severe downturn in the unit price of the note during the latter stages of 2015, which compounded by the 2x leverage caused LMLP to stray within striking distance of the $5 level, below which the fund would have become automatically liquidated.

Chart

LMLP data by YCharts

Is LMLP a good investment now? The 12% yield is attractive, but be aware that the fund tracks a very concentrated index in both sector (ex-energy MLPs only) and weighting (the top 10 holdings making up more than 90% (!) of the index). Combined with the 2x leverage, this note is definitely not for the fainthearted.

Is there any other data that you would like to be included in the ETRACS 2x leveraged ETN Snapshot? If so, please let me know.

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.

Additional disclosure: I am long the portfolio securities.

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