ETRACS 2x Leveraged ETN Snapshot, September 2018: The Best Diversifiers To U.S. Stocks?

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Includes: AMLP, BDCL, BDCS, CEFL, DVHL, DVY, DVYL, HDLV, HOML, IMLP, LBDC, LMLP, LRET, MLPI, MLPQ, MLPZ, MORL, MORT, MRRL, SDY, SDYL, SMHD, SPLX, SPY, VNQ, YYY
by: Stanford Chemist

Summary

MORL/MRRL are the highest-yielding 2x ETNs, followed by SMHD and CEFL.

3-month LIBOR decreased by 3 bps this month, and has been little-changed since April.

All 2x ETNs are correlated to the U.S. market, but relatively speaking, the "alternative equity" funds may act as the best diversifiers.

For the inaugural edition of the ETRACS 2x Leveraged ETN Snapshot, please see here. Data are taken from the close of August 6, 2018. Previous articles on the Snapshot can be searched using the keyword "ciletn".

Fund additions, closures, or notable adjustments

None this month. Note that the ETRACS Monthly Reset 2xLeveraged S&P 500 Total Return ETN (NYSEARCA:SPLX) was accelerated (redeemed) in June.

The funds

Fund Ticker Inception Assets / m Volume / k Yield TER Adjusted TER 1x fund
Equity
Monthly Pay 2xLeveraged S&P Dividend ETN (SDYL) 5/2012 17.1 1.1 4.87% 0.70% 1.51% (SDY)
Monthly Pay 2xLeveraged Dow Jones Select Dividend Index ETN (DVYL) 5/2012 42.8 3.4 6.86% 0.75% 1.54% (DVY)
Monthly Pay 2xLeveraged US High Dividend Low Volatility ETN (HDLV) 9/2014 19.0 5.6 10.90% 1.45% 1.89%
Monthly Pay 2xLeveraged US Small Cap High Dividend ETN (SMHD) 3/2015 61.2 39.6 18.38% 1.65% 1.99%
Monthly Reset 2xLeveraged ISE Exclusively Homebuilders ETN (HOML) 3/2015 4.0 0.5 0.00% 1.65% 1.99%
Alternative equity
Monthly Pay 2xLeveraged Wells Fargo MLP Ex-Energy ETN (LMLP) 6/2014 29.5 16.0 12.64% 1.45% 1.89%
Monthly Pay 2xLeveraged MSCI US REIT Index ETN (LRET) 5/2015 5.9 2.0 7.76% 1.65% 1.99% (VNQ)
Monthly Pay 2xLeveraged Mortgage REIT ETN (MORL) 10/2012 495.6 267.2 20.17% 0.80% 1.56% (MORT)
Monthly Pay 2xLeveraged Mortgage REIT ETN Series B (MRRL) 10/2015 14.1 9.7 20.17% 0.80% 1.56% (MORT)
2xMonthly Leveraged Alerian MLP Infrastructure Index ETN Series B (MLPQ) 2/2016 94.7 3.0 0.00% 1.65% 1.99% (MLPI) (AMLP)
2xMonthly Leveraged S&P MLP Index ETN Series B (MLPZ) 2/2016 36.8 1.0 10.44% 1.95% 2.14% (IMLP)
2xLeveraged Long Wells Fargo Business Development Company Index ETN (BDCL) 5/2011 238.8 145.6 15.46% 0.85% 1.59% (BDCS)
2xLeveraged Long Wells Fargo Business Development Company Index ETN Series B (LBDC) 10/2015 6.5 1.4 15.46% 0.85% 1.59% (BDCS)
Balanced
Monthly Pay 2xLeveraged Closed-End Fund ETN (CEFL) 12/2013 249.6 146.2 17.48% 0.90% 1.61% (YYY)
Monthly Pay 2xLeveraged Diversified High Income ETN (DVHL) 11/2013 22.7 8.2 13.49% 1.25% 1.79%

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 mouth-watering 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 20.2% yield, followed by SMHD at 18.4% and CEFL at 17.5%. All of the ETNs pay monthly except for BDCL/LBDC, MLPQ and MLPZ which pay quarterly (and except for HOMX which pays no distributions at all).

(Source: Stanford Chemist, Morningstar)

Dividend growth rate

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. See this Lance Brofman article for a detailed explanation.

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 2.32%). Adding all three fees together gives a total expense ratio [TER] of 0.30% (tracking rate) + 0.40% (financing spread) + 2.32% (3-month LIBOR) = 3.02%.

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 2.14%. SDYL has the lowest expense ratio (excluding LIBOR) of 0.70%, and its adjusted TER comes out to 1.51%.

(Source: Stanford Chemist, Morningstar)

The 3-month LIBOR rate has fallen by 3 basis points this past month. Overall, there has been little change in the rate over the last several months, giving relief to 2x ETN leveraged expense ratios.

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 unreliable due to the low liquidity of some of the ETNs.

BDCL and LBDC appear to have fallen all the way down from towards the top of their 52-week trading ranges into the middle of the range. Yet, the share price has been stable over the last month. What happened?

Apparently, Morningstar has changed how they calculated their 52-week highs and lows. Last month, Morningstar quoted a 52-week high of $16.41 for BDCL, which I deduce was based on the total return price series (adjusted for distributions) (lower panel of the chart below). However, this month the quote was $18.58, based on the actual trade price at the time (upper panel), meaning that BDCL (and LBDC) magically shifted lower within their 52-week range even with little change in price.

Chart

BDCL data by YCharts

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. The figures on the chart show the 1 year total return percentages.

(Source: Stanford Chemist, Morningstar)

We can see from the chart above that there is a large variation between the 1-year TR performances of the 2x ETNs. SDYL (+31%) and DVYL (+25%) are the top two 2x leveraged ETNs. The worst ETN by 1-year return is HDLV (-4% total return).

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. This could be because UBS still has a reservoir of "Previously Issued But Unsold Notes Available for UBS Securities LLC to Sell" for each ETN, allowing supply to match demand until the reservoir becomes fully exhausted.

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 CEF/ETF Income Laboratory, but has been released to the public as part of my Back to School Free Trial and -20% Discount Promotion)

In this month's quick commentary, I'd like to ask the question: which ETNs are the best diversifiers to U.S. stocks? This may be an especially pertinent question to ask as domestic markets race to new highs (again), could any of the 2x ETNs be expected to provide downside protection in the case of a steep market correction?

To answer this question, I used InvestSpy to calculate the 2-year correlation coefficients for the ETRACS 2x ETNs with U.S. large cap stocks (SPY). The results are shown in the table below.

SDYL

DVYL

HDLV

SMHD

HOML

LMLP

LRET

MORL

MLPQ

MLPZ

BDCL

CEFL

DVHL

SPY

SDYL

1.00

0.61

0.45

0.46

0.20

0.44

0.31

0.32

0.32

0.19

0.38

0.37

0.46

0.51

DVYL

0.61

1.00

0.62

0.61

0.16

0.58

0.42

0.43

0.40

0.17

0.40

0.50

0.60

0.73

HDLV

0.45

0.62

1.00

0.56

0.12

0.37

0.61

0.52

0.29

0.10

0.34

0.43

0.55

0.49

SMHD

0.46

0.61

0.56

1.00

0.15

0.46

0.47

0.54

0.39

0.17

0.48

0.41

0.61

0.50

HOML

0.20

0.16

0.12

0.15

1.00

0.20

0.09

0.08

0.12

0.09

0.16

0.10

0.16

0.17

LMLP

0.44

0.58

0.37

0.46

0.20

1.00

0.24

0.32

0.43

0.20

0.44

0.48

0.54

0.68

LRET

0.31

0.42

0.61

0.47

0.09

0.24

1.00

0.41

0.21

0.11

0.27

0.32

0.49

0.31

MORL

0.32

0.43

0.52

0.54

0.08

0.32

0.41

1.00

0.22

0.08

0.44

0.44

0.51

0.42

MLPQ

0.32

0.40

0.29

0.39

0.12

0.43

0.21

0.22

1.00

0.43

0.33

0.36

0.68

0.44

MLPZ

0.19

0.17

0.10

0.17

0.09

0.20

0.11

0.08

0.43

1.00

0.22

0.19

0.36

0.17

BDCL

0.38

0.40

0.34

0.48

0.16

0.44

0.27

0.44

0.33

0.22

1.00

0.47

0.51

0.42

CEFL

0.37

0.50

0.43

0.41

0.10

0.48

0.32

0.44

0.36

0.19

0.47

1.00

0.52

0.62

DVHL

0.46

0.60

0.55

0.61

0.16

0.54

0.49

0.51

0.68

0.36

0.51

0.52

1.00

0.56

SPY

0.51

0.73

0.49

0.50

0.17

0.68

0.31

0.42

0.44

0.17

0.42

0.62

0.56

1.00

To make the correlation with U.S. stocks easier to see, I created a chart showing only the correlation values to SPY. The funds are color coded in the chart below; blue for equity funds, orange for alternative equity funds, and green for balanced funds.

(Source: Stanford Chemist, InvestSpy)

The first thing to note from the data above is that all of the 2x ETNs have positive correlation coefficients with the market. In other words, if the markets go up, the ETNs have the tendency to go up, and when the markets go down, the ETNs tend to go down with it. For most of the funds, the correlation can be considered to be moderate (0.40 to 0.60). This means that one should not necessarily expect the ETNs to act as a "hedge" in times of market duress.

Another thing I should point out is that the correlation values for some of the less liquid ETNs are not expected to be reliable. This is because the correlation coefficients are calculated on the basis of daily price moves; if there is no price movement registered (due to lack of trading activity), then the correlation with SPY will be computed to be artificially low. Ideally, I would be tracking the correlation between SPY and the underlying indices (instead of the ETNs themselves) but InvestSpy does not seem to have this option. As a result, I believe that the low correlation values of HOML, SDYL, MLPZ and LRET are not accurate and should not be relied upon to form conclusions (their bars are pattern-shaded in the chart above).

After excluding the anomalies, the ETNs with the lowest correlation to U.S. stocks over the past two years are MORL (0.42) and BDCL (0.42), followed by MLPZ (0.44). These are all "alternative equity" funds, and their lower correlation to general equities might be expected. MORL (tracking mREITs) and BDCL (tracking BDCs) have significant dependencies on interest rates and spreads, while MLPZ (tracking MLPs) are largely exposed to energy and commodities concerns.

The ETNs with the highest correlation to the market over the past two years are DVYL (0.73) and LMLP (0.68), followed by CEFL (0.62). The high correlation of DVYL, being composed of domestic large-cap dividend payers, is not a surprise result. LMLP, tracking ex-energy MLPs (including private equity firms), would also be expected to move with the market. The moderately high correlation of CEFL might be surprising to some; after all, doesn't CEFL hold a basket of high-yielding (including many fixed income CEFs)? But here, one needs to remember that the premium/discount values of CEFs are highly influenced by market sentiment. In times of market stress, discounts often widen regardless of underlying portfolio quality or NAV, leading to a depression in the share price of CEFL (and thus accounting for the high correlation to SPY).

Finally, to revisit the low liquidity problem, I had the idea to compute the 2-year correlation coefficients of more liquid 1x leveraged proxies so that we could help gauge the "true" correlation of the funds to the broader market. SPDR S&P Dividend ETF (NYSEARCA:SDY) and iShares Select Dividend ETF (NYSEARCA:DVY) are the 1x leveraged versions of SDYL and DVYL respectively. SDY and DVY show high correlation values (0.87 and 0.84) to SPY, as we'd expect. Vanguard REIT ETF (VNQ), the 1x version of LRET, shows a 0.44 correlation with SPY.

To conclude, the ETRACS 2x ETNs are moderately to highly correlated with the general U.S. equity markets. As such, they should not be considered as hedges to the market in any way, shape or form. Relatively speaking, the most effective diversifiers would be the "alternative equity" funds such as MORL, BDCL/LBDC, and MLPQ/MLPZ.

Disclosure: I am/we are long THE PORTFOLIO SECURITIES.

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.