MORL: Double Yield And Double Annualized Volatility

Josh Ortner profile picture
Josh Ortner
1.18K Followers

Summary

  • The ETRACS Monthly Pay 2x Leveraged Mortgage REIT ETN continues to draw investors attention with it's 18.6% dividend yield.
  • Before investing in MORL, investors need to understand the credit risks of this ETN and the leverage risks involved.
  • MORL has earned a CAGR of 13.39% while experiencing extreme volatility measured in standard deviation of over 26% annually.

After researching the UBS ETRACS Monthly Pay 2x Leveraged Mortgage REIT ETN (NYSEARCA:MORL) for a Seeking Alpha reader, I felt an urge to write about this product individually on all the hidden risks involved with this type of exchange traded note. When I see any investment yielding over the risk-free treasury rate, my analytical background attempts to uncover how this type of note can sport such a high yield? This note specifically was created by global investment bank UBS (UBS). These exchange traded notes give investors 2x the leverage of their original investment, and sometimes even 2x the yield. One of such note that I personally owned for a month, doesn't trade anymore with good reason. This note was the ETRACS 2x Alerian MLP index ETN (MLPL), which was discontinued after the Alerian MLP index continued to drawdown in value. One should note, this index still hasn't recovered any of those losses since the MLPL product was discontinued. These ETNs are not suitable for retired investors, especially those who are purchasing them for yield. These exchange traded notes are purely speculative trading vehicles, at best. After reading this article, current shareholders of these notes should revisit their original investment thesis on owning such a leveraged product.

Exchange Traded Note Credit Risk

An ETN is typically issued by an investment bank or financial company that attempts to track a certain index or benchmark. These notes are unsecured debt obligations issued by the organization, and are not the same as purchasing a common stock or mutual fund. Lets take a look below at what UBS states specifically about the credit risk of its ETN's in general below:

As a result, the actual and perceived creditworthiness of UBS will affect the market value, if any, of the ETNs prior to maturity or call, or upon acceleration or upon early redemption. In addition, in the event UBS were to default on its obligations, you may not receive any amounts owed to you under the terms of the ETNs.

When I purchase a product from a bank, I do not want my original principal to be solely tied to the credit worthiness of a bank, without some type of FDIC guarantee. This type of note is much different than owning say an exchange traded fund that owns common stocks or bonds of a specific index. The market value of the ETN on any given day could decline due to a downgrade in the issuer's credit rating, even though there was no change in the underlying index. This is another reason for investors to be very skeptical about buying any ETN of a bank that might have questionable long-term financial conditions. You are better off owning a passive index exchange traded fund.

The Call Right

What many investors do not realize is that ETNs are always issued with a maturity date, and usually with a call provision within the prospectus. I have come to find that these securities are likely to be called by the bank when the current market environment negatively changes.

UBS may redeem all outstanding ETNs at any time on or after the date specified in the pricing supplement, as described in the ETRACS Prospectus.

In other words, you are giving UBS the right to determine when you exit this security, at any time. If you want to dollar cost average into this security as it drops in price, there is a real risk of you not knowing what the last trading day could be. Just like with MLPL, the issuing bank can redeem shares and exit you at a loss. From a risk management perspective, its hard to develop a plan to protect yourself from losses, as we truly do not know if the product will even be trading tomorrow. You can find more about the call right and credit worthiness on UBS's website.

Extreme Volatility

My main argument against MORL and these type of exchange traded notes is the extreme volatility one has to experience in order to earn 18.6% in dividend yield. When reading the reasons why an investor should purchase this security, I did not see any reference to the risk metrics to the exact product. When I perform any ETF analysis for clients, I always run the risk metrics and explain in detail what it means to the client in English. Lets take a look below at a few risk metrics of MORL:

Metric MORL
Arithmetic Mean (monthly) 1.34%
Arithmetic Mean (annualized) 17.37%
Geometric Mean (monthly) 1.05%
Geometric Mean (annualized) 13.39%
Volatility (monthly) 7.61%
Volatility (annualized) 26.36%
Downside Deviation (monthly) 5.05%
Max. Drawdown -36.79%
US Market Correlation 0.52
Beta 1.20
Alpha (annualized) -0.42%
R2 27.19%

(Source: Portfolio Visualizer)

Since MORL's inception in 2012, the fund has indeed produced a 13.3% compounded annual growth rate, which seems pretty good, right? Not so fast. While earning this yield, an investor in this product has experienced at least one -36.79% max-drawdown, and a 26.36% annual volatility in price. In order for you to earn this 13.3% return, you have to be willing to watch your account fluctuate up and down 26.36% in value. Yikes! If that is not bad enough, the monthly volatility measurement on the ETN is over 7.61% per month. If you are thinking about purchasing this note for the monthly income, you should probably think twice. According to Portfolio Visualizer, the positive monthly return rate for this fund is only 66.27%. When you consider earning 18.6% in dividend, is it really worth only earning an 13.3% annual total return while experiencing so much volatility, even in the best bull market on record?

Mortgage REIT's With Leverage vs. No Leverage

I would be doing the Seeking Alpha reader a disservice by not discussing the impact of leverage. Leverage is a double edged sword. Investors need to study the impact of decay on leveraged notes. Decay is the loss of performance attributed to the multiplying effect on returns of the underlying index of the leveraged notes. Since leverage needs to be reset on a daily market basis, volatility is your greatest enemy, where we already mentioned above that the volatility on MORL is extremely high. Larger returns will be required in order to get you back to even on this note, due to this decay. The best way to illustrate the negative decay is to compare MORL to a non-leveraged Mortgage REIT ETF such as the VanEck Mortgage REIT ETF below:

Year (MORL) (MORT)
2013 -2.73% 1.11%
2014 36.33% 17.89%
2015 -21.04% -9.80%
2016 47.11% 21.88%
2017 36.95% 18.84%
2018 -11.40% -4.45%
2019 27.60% 17.35%

(Source: Portfolio Visualizer)

As you can see from the above chart, this double leverage of MORL acts two different ways. When the index value is dropping like it did in 2018, the negative compounding and decay effect take over. The investor would have to know exactly when the index is going to trend higher for the compounding effect to help them. Instead of worrying about how to compute this daily compounding and decay effect, look at a non-leveraged fund like (MORT). If you are an investor who needs a higher yield and wants exposure to the Mortgage REIT asset class, you do not need a leveraged product. When I compared the MORL to the VanEck Vectors Mortgage REIT Income ETF, the investor can experience a yield of 9.89% with much less volatility and more consistency. The MORT offers pure play exposure to mortgage REITs, and high yields as well. MORT offers investors that 9.89% yield with a standard deviation of only 13%, vs. the 26.35% volatility reading with MORL. This price volatility is very important to consider when only focusing just on yield.

The Bottom Line

Products such as MORL are not suitable for investors, only short-term traders. From credit risk, to call risk, to the leverage decay, this product is asking for long-term trouble. Very large yield figures always attract capital. Most investors do not consider how the note is achieving this ultra-high yield, and what the impacts are when the index drops due to a bear market environment. Instead of purchasing a leveraged ETN like MORL, the investor can consider MORT, which is not exposed to the above risks while still earning a very respectable 9.89% yield. MORL is generally designed for short-term plays on an index or sector. This note is designed to eat away at your capital in more ways than one, including fees, re-balancing, and compounding losses. Do yourself a favor, and look at purchasing MORT instead of MORL.

This article was written by

Josh Ortner profile picture
1.18K Followers
Mr. Ortner is a published author in areas focusing on anti-money laundering and risk management. He focuses his writing on the importance in reviewing the fine prints of complex financial products and offerings. Mr. Ortner is currently a Certified Anti-Money Laundering Specialist. All articles are opinions of Mr. Ortner and should never be construed as personal financial advice.
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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: These are opinions of Mr. Josh Ortner, CTFA, and should not be construed as personal financial advice. Mr. Ortner urges investors to read the prospectus of MORL & MORT before investing.

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