What a Difference a Month Makes

Here is a quick note on last week’s announcement by UBS that they will be closing two of their leveraged ETNs, exchange traded notes, that track Master Limited Partnerships (MLPs). These are the ETRACS 2x Monthly Leveraged Long Alerian MLP Infrastructure ETN (Ticker: MLPL) and the ETRACS 2x Monthly Leveraged S&P MLP Index ETN (Ticker MLPV). UBS announced that the notes, which are actually debt instruments set to expire in 2014 and 2045, are subject to mandatory redemption.1  

Risks for Leveraged ETNs

The Risks of ‘Monthly Reset’ for ETFs and ETNs

One of the main criticisms of ETFs (and inverse ETFs) is that daily rebalancing exacerbates compounding risk since the resets would mathematically make tracking or correlating to the movement of an index diverge over time. It appears that while no ETF or ETN product is perfect, the daily resets might actually be a less volatile alternative. The abrupt closing of these two UBS funds reminds us on the infamous TVIX debacle from 2014 when the fund’s value imploded as issuers decided to open up the shares outstanding which had been closely regulated by arbitrageurs. The specifics here are quite different but the result is the same, serious headaches for owners. Remember, exchange traded notes have no ‘assets’ since they are a debt instrument.

While these concerns still exist, many thought a monthly reset would be optimal and lessen these negative compounding effects. It is now evident that monthly resets, especially for leveraged ETNs, could be big trouble for investors when the underlying benchmark is collapsing. The price of crude oil has done just that and caused many stocks and ETFs in the energy space to lose significant value. This is also evident with the MLPs, who have been hammered, down over 62% for the Alerian MLP Index from its 54.13 high in September 2014 to its low of 20.35 this month. The losses really accelerated recently, as the index is also down over 40% in just the last 3 months. (Ironically, that was one of the marketing points for the use of MLPs was that it was a toll booth that wasn’t dependent on the price of oil).

As unfortunate as it is, it appears that these 2x leveraged ETNs actually did achieve the return they had been designed to do. A monthly drop in oil of 28.3% over their monthly reset period, resulted in a 56.6% loss since it was a 2x product. So, the product ‘worked’ as it was designed. But it was the ‘acceleration event’ and subsequent closing that was so surprising to many investors.

What is an Acceleration Event?

This obscure term should become much more mainstream as investors and the media begin to dig deeper into the prospectuses of these ETN offerings. An acceleraton event is a predetermined value, spelled out in the terms of the security, when the issuer can automatically redeem the notes from the owners. In this case, it was the intraday index value decreasing by more than 30% from the most recent monthly initial closing level. ”*Investors will receive the Accelerated Amount on the Accelerated Settlement Date, February 1st.

Lessons to be Learned from MLPL and MLPV

This is why counterparty risk is so important and why we use that as a factor when determining our Best Inverse ETFs list and Best Alternative ETF list. When the inverse ETF, or in this case leveraged ETN, is issued and controlled by one entity, in this case UBS, there are two concerns: 1- High counterparty risk since all your eggs are in one basket and 2- There is the possibility that the single counterparty will act in its own best interests at the end of the day, especially if it happens to be in financial trouble down the road (UBS is not in that boat currently). With just one underwriter/counterparty (who is probably their internal trading desk) they can be self-serving. Just like in covenant lite high-yield corporate bond prospectus, the devil is in the details. According to their website, UBS has 41 ETNs including the two closing funds.

Another lesson is that the safety of holding [long] ETFs and ETNs again comes into question. There is a need for hedging of these instruments. We understand it may seem a bit odd to hedge [long] ETF exposure with an inverse ETF but as we’ve seen with the latest ‘flash crash’ this past August, the high concentration risk of ETFs like XLF and QQQ were exposed when market makers stepped away after individual components were halted for trading, disallowing the market makers to get an accurate assessment of the total ETFs value. In fact, the ProShares Trust Short QQQ ETF (Ticker: PSQ) which is the inverse of the QQQs (not actually the NASDAQ 100 index per say) actually benefitted from the QQQs troubles and opened that much higher in the first few minutes of trading, tracking the QQQ quite well.

For an aggressive investor, a simpler idea might be to buy an individual MLP or an MLP ETF (1x) and buy it on margin from your broker, thus giving you the double exposure. There are too many caveats with these 2x ETNs and they should be really scrutinized before purchase.