REML: A Case Study Against Leveraged ETNs And Products
Summary
- REML is a leveraged ETN, or exchange-traded note.
- Structured leveraged products, including REML, consistently underperform, and are generally disastrous products.
- An overview of REML, and of leveraged ETNs more broadly, follows.
- This idea was discussed in more depth with members of my private investing community, CEF/ETF Income Laboratory. Learn More »
The Credit Suisse X-Links Monthly Pay 2x Leveraged Mortgage REIT ETN (NYSEARCA:REML) is exactly what it says on the tin: a 2x leveraged mortgage REIT ETN.
Leveraged ETNs such as REML are a bit of a niche product, but sometimes popular in retirement circles due to their strong yields. Due to this, I thought to write something about these products, how they work, and some of the risks with leveraged products.
Leverage boosts gains during rising markets, and could lead to outstanding and market-beating returns.
Leverage boosts losses during downturns, and could lead to significant, unrecovarable losses during severe downturns.
The net effect of leverage depends on many factors. For funds or products focusing on niche, volatile industries, the net effect tends to be negative, due to the number and depths of its downturns. As such, investors should generally avoid leveraged products or funds focusing on niche, volatile industries, including REML.
Leveraged ETNs - Overview
A quick overview of how ETNs, including REML, work.
In simple terms, ETNs are generally senior, unsecured debt securities issued by a financial institution whose prices, coupons, and returns are tied to the value of an index during a specified time period.
In even simpler terms, ETNs are contracts with a bank entitling you to a set of returns.
In the case of REML, the securities are issued by Credit Suisse (CS), and you are entitled to twice the monthly returns of the FTSE NAREIT All Mortgage Capped Index. Said index focuses on the volatile and risky mREIT industry, which encompasses companies which invest in mortgage securities directly, and through the use of leverage. Expected returns include capital gains (and losses) plus dividends.
You are entitled to these returns because the contract says that you are. It is extremely likely that Credit Suisse enters into a complicated set of derivatives trades to ensure that they receive the specified returns, but these trades are incidental. You are entitled to the specified returns, regardless of what Credit Suisse does, or does not do to obtain these. There is some credit risk for these securities, perhaps Credit Suisse goes bankrupt and can’t pay, but this is generally quite low. Banks are not in the business of going bankrupt.
With the above in mind, let's have a look at some of the positives of these products.
Leveraged ETNs - Positives
Leveraged ETNs have two key benefits: their strong yields, and their strong capital gains during rising markets. Let's have a look at each of these points.
Strong Yields
REML itself yields 11.5%, significantly more than its underlying index, as tracked by the iShares Mortgage Real Estate Capped ETF (REM), or broader stock market indexes.
Higher dividend yields directly increase shareholder returns, and are almost always a positive. Double-digit yields are quite rare, and quite enticing, especially under current market conditions.
Strong Capital Gains During Rising Markets
REML also tends to perform exceedingly well during rising markets. As an example, the fund has doubled in value during the past six months, vastly outpacing the returns of its underlying index, broader stock market indexes, and even growth funds like the ARK Innovation ETF (ARKK). Outperformance is almost always exclusively due to the fact that REML is leveraged, and returns are a multiple of its index.
Stronger capital gains are, of course, a significant benefit for the fund and its shareholders. As these should occur during rising markets, and as markets mostly tend to rise, one would think REML's long-term returns are quite good, but the truth is a bit more complicated. Let's have a look.
Leveraged ETNs - Negatives
Leveraged ETNs have three key negatives: their complicated structures, their high fees, and their significant losses during downturns. Let's have a look at each of these points.
Complicated Structures
ETNs, unlike more traditional ETFs, CEFs, or single-name securities, are complicated products, although REML less than other ETNs. Returns are dependent on complex contractual arrangements and formulas. Products are structured by banks, and you can be certain that the structure and product specifications are to the benefit of the bank, and to the detriment of shareholders.
Due to the complexity of ETNs, it is very difficult to actually prove the above, but Morningstar has done some very interesting research on the subject. As per Morningstar:
The complex design of structured notes makes it tough for investors to understand exactly what they’re getting (...)
Notwithstanding the above, you can analyze ETNs, although using complicated methods like Monte Carlo simulations. They do just that for a specific ETN and find that:
the expected value of all the payouts stands at $1,033, which translates (roughly) into a 1.65% mean rate of annualized return. That’s quite a difference from the maximum 9.1% rate of annualized return that the investor is teased into expecting by the note’s coupon.
In simple terms, Morningstar showed that the expected returns of a structured note with a 9.1% yield are 1.65%, very low. Showing that this is the case is, as mentioned previously, quite difficult, which is on purpose. 9.1% yields are attractive for investors, and 1.65% returns are quite low, so banks make bank from these products. Shareholders generally don't, but most don't know this.
Although Morningstar showed that this is the case for only one specific structured product, I'm confident that this is the case for most, if perhaps not all, similar products, including REML.
REML's 11.5% yield looks quite attractive, but expected returns are almost certainly lower. Don't be fooled by the yield.
High Fees
Leveraged ETNs generally charge high fees, the price paid for their complexity. REML itself charges investors 1.3% + LIBOR in fees. High fees directly reduce shareholder returns, and are a significant negative for the fund and its shareholders.
High fees don't mean you can't profit from these products, but it does make it difficult.
I'm also generally wary of high fees, as these necessarily decrease shareholder returns, while yields and capital gains are somewhat uncertain. Trading a certain loss for an uncertain, if perhaps stronger, gain is rarely a good idea.
Significant Losses during Downturns
Leveraged ETNs tend to significantly underperform during downturns due to their use of leverage.
REML itself posted losses of just over 88% during the last downturn, at the beginning of the coronavirus pandemic. The fund significantly underperformed its parent index, its peers, and other equity index funds.
REML's sizable losses actually underplay the severity of the fund's issues. REML's underlying index suffered losses greater than 50%, which should have wiped out shareholders completely. Investors avoided the worst as Credit Suisse modified the fund's contract, allowing shareholders to recover as the downturn abated. Other ETNs were not spared, and investors should not expect such forbearance to be repeated.
REML should suffer significant losses during other downturns, and there is a distinct risk that shareholders lose their entire investment.
REML is risky enough that, in my opinion, it is wholly inappropriate for most investors and retirees. Only the most bullish, aggressive investors should even consider initiating a position, and even then I'm bearish about the fund's long-term returns.
Leveraged ETNs - Net Negative Product
Leveraged ETNs have many pros and cons, with the net effect of these being dependent on quite a few variables.
Although these are complex products, we can summarize their expected performance thus.
Leveraged products amplify both gains and losses. The more frequent and severe the downturns, the worse these products perform, and vice versa. If downturns are particularly severe, investors run the risk of suffering irrecoverable losses.
The above has been the case for REML since inception, with the fund significantly underperforming its parent index, even though unleveraged returns have been reasonably strong.
As mentioned previously, the above is due to the fact that REML's leverage amplified losses during the previous downturn. These losses were severe enough that the fund was simply unable to recover.
In my opinion, REML's underlying index is volatile enough that investors should expect similar losses and returns to the ones above. I believe this as the fund's underlying index is quite volatile, and prone to significant losses during downturns. As an example, the parent index was down by more than 42% during the past financial crisis. This implies returns of about -84% for REML.
In practice, REML's investors should expect to suffer periodic +80% losses, due to the risk and volatility of the fund's underlying index. These losses are quite significant, and more than outweigh the fund's other positives.
Conclusion - Avoid Leveraged ETNs
Leveraged ETNs, including REML, tend to significantly underperform during downturns, and during the very long term. As such, I see little reason to invest in these funds.
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This article was written by
Juan has previously worked as a fixed income trader, financial analyst, operations analyst, and economics professor in Canada and Colombia. He has hands-on experience analyzing, trading, and negotiating fixed-income securities, including bonds, money markets, and interbank trade financing, across markets and currencies. He focuses on dividend, bond, and income funds, with a strong focus on ETFs, and enjoys researching strategies for income investors to increase their returns while lowering risk.
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Analyst’s 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.
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Comments (90)
I did some analysis of the divy payout as follows:
Total per month
2019 4.8431 0.404
2020 1.76 0.146
2021 0.4782 0.096I am thinking that we will get $2-$3 Total for 2021 as we see May is 0.0541 more than double Feb div of 0.0178. I say buy now!!
seekingalpha.com/...
You'll see they did well in 2012 and 2013 just as the spread widened during then.From 2014 to recently the spread was contracting so mREIT dividends were cut during those years. But the spread has been expanding dramatically since 2020 which foretells rising earnings from the mREIT sector and why I'm very bullish on REML
You need to speak to forward issues, not history.
I’m up 78% from buy in 2020. I like that and it raised its distribution 35% as predicted by others.
jcm
