Triple Threat: These New Leveraged ETFs Own Leveraged Funds That Own Leveraged Companies - Barron's

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The Leverage Upon Leverage Upon Leverage Close-End Fund ETN

By Lewis Braham

After the worst market downturn in more than a decade, it’s surprising to see money managers launching new products that leverage investors’ exposure to market risks. But that is precisely what UBS is doing with the launch of its ETRACS Monthly Pay 1.5X Leveraged Closed-End Fund Index ETN (ticker: CEFD) and three other leveraged exchange-traded notes this June.

The launch is unusual for a number of reasons. This March, UBS announced the mandatory liquidation of its ETRACS Monthly Pay 2x Leveraged Closed-End Fund ETN (CEFL). That ETN—which aimed to deliver twice the monthly return of the ISE High Income Index of the 30 highest-yielding closed-end funds trading at discounts—had fallen more than 80% in value from over $14 a share in February to a low of $1.52 on March 18 during the coronavirus crisis, which triggered an automatic prospectus-mandated redemption “as a result of the respective indicative values of the securities being less than $5.00 on the Acceleration Date,” according to the press release. UBS declined to comment for this story.

The new ETN invests in a more diversified basket of 125 income-producing closed-end funds in the S-Network Composite Closed-End Fund Index; like its predecessor, its primary goal is to maximize income by borrowing money to make additional investments. It will use less leverage, however, aiming for 1.5 times the quarterly returns of its closed-end fund benchmark instead of the previous ETN’s two times monthly benchmark return. But it is risky nonetheless. Consider that closed-end funds generally employ leverage themselves, so this ETN is effectively leveraging its underlying funds leverage. Closed-end funds generally limit their leverage to 1.5 times their portfolios, too, although through the use of derivatives that can sometimes go higher. Now multiply 1.5 leverage times 1.5 leverage and you get a maximum exposure of 2.25 times the closed-end funds’ portfolio securities.

Of course, the closed-end fund’s stocks or bonds can be securities of companies that have leverage on their balance sheet, too. As of the end of March 38% of the benchmark the ETRACS ETN tracks, S-Network Composite Closed-End Fund Index, was invested in high-yield bond closed-end funds investing in highly leveraged companies’ debt. The remainder of the benchmark portfolio was about equally split in investment-grade bond funds and funds that writes options on stocks to generate income. Generally, the more risky the stock, the higher the option income.

If all of this sounds dangerous, consider that closed-end funds also often don’t trade at the value of their underlying portfolios, or net asset values (NAVs), in Wall Street parlance. Instead, closed-end funds frequently trade at significant discounts to NAV during periods of stress. If a discount widens during a downturn, losses are amplified to the end shareholder. Leverage on a portfolio of closed-ends will further amplify this discount effect.

To top it off, ETNs are a form of leverage themselves as they are debt notes, in this case issued by UBS. Although that doesn’t affect the performance of the underlying portfolio, it means that if UBS were to go bankrupt, ETRACS investors could still lose their money even if closed-end funds were doing well. That applies to the other new ETRACS, which also lever already-volatile leveraged investments: ETRACS Quarterly Pay 1.5X Leveraged Alerian MLP Index (MLPR), ETRACS Quarterly Pay 1.5X Leveraged Wells Fargo BDC Index (BDCX) and ETRACS Monthly Pay 1.5X Leveraged Mortgage REIT (MVRL).

The closed-end ETRACS has some safeguards in place in that if its price declines by 50%, it automatically eliminates the leverage and if it declines by two-thirds, 66.6%, it enters liquidation mode. But a similar liquidation guardrail didn’t work so well for the defunct 2X closed-end ETN.

“In our opinion, leveraged ETNs are not appropriate for the individual investor,” says Eric Boughton, co-manager of the Matisse Discounted Closed-End Fund Strategy (MDCEX), which also invests in closed-ends, but without leverage. “However, [the ETRACS closed-end ETN] is likely to deliver acceptable risk-adjusted returns, since leverage is cheap, and [closed-end funds] are highly discounted today, setting the stage for attractive returns.”

That said, if the market goes south instead of north, it could be one wild ride.

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