Summary A previous article showed that the ETRACS 2x ETNs did not inexorably decay in value even over several years. Other authors have investigated the idea of using leveraged funds to build your own ETF. The application of this strategy to the ETRACS 2x ETNs are investigated, revealing the potential for additional yield. Introduction The ETRACS line-up of ETNs issued by UBS (NYSE: UBS ) provides investors with exposure to a broad range of investment classes. A number of the ETRACS ETNs are 2x leveraged, which means that they seek to return twice the total return of the underlying index, minus fees. This allows the ETNs to offer alluring headline yields, making them attractive for income investors. Additionally, some of these funds pay monthly distributions, although these can be lumpy. A recent article provides an overview of the types, yields and expense ratios of these 2x leveraged ETNs. An interesting feature of the 2X leveraged ETNs is that their leverage resets monthly rather than daily, which is the norm for most leveraged funds on the market. It is 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, this decay can be somewhat mitigated. An article by Seeking Alpha author Dane Van Domelen addresses the decay issue mathematically and shows that in most cases, the decay is not as serious as is often thought. However, this leverage does not come without costs. There is the management cost associated with providing the ETN, as well as a finance cost associated with maintaining the 2x leverage. Finally, it should be noted that investors in 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. However, 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 at net asset value. I recently studied the performance of several of the 2x leveraged ETNs and found that, in general, the 2x ETNs fulfilled their objectives and also outperformed the corresponding (hypothetical) daily-reset 2x ETNs. This suggests that, over the last few years at least, that the 2x ETNs have been suitable (insofar as them being able to meet their objectives vis-a-vis their 1x counterparts) long-term instruments for the leverage-seeking investor. Just to make this point crystal clear, the 2x ETRACS ETNs have allowed aggressive investors to obtain 2x participation in a variety of asset classes in an efficient and stable manner – both to the upside and to the downside – I am not making specific recommendations as to whether the asset classes themselves (e.g. mREITs, MLPs, BDCs, and CEFs, just to name a few of the asset types covered by the ETRACS) are suitable as long-term investments. Building your own ETF In another article entitled ” Build Your Own Leveraged ETF “, Dane Van Domelen explores the possibility of combining leveraged ETFs with cash or other funds for various purposes. For example, Dane posited that a one-third ProShares UltraPro S&P 500 ETF (NYSEARCA: UPRO ), a 3x leveraged version of the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ), two-thirds cash portfolio has virtually the same properties as a 100% S&P 500 portfolio (with periodic rebalancing), but allows you to hold a lot of cash: An interesting special case is where you put one-third of your money in UPRO and two-thirds in cash. At the onset, this portfolio would behave almost exactly as if you had all of your money in the S&P 500. UPRO’s expense ratio should result in somewhat diminished returns, but not much. And it might be worth it to free up two-thirds of your money, for emergencies and so forth. UBS 2x ETN expert Lance Brofman has also considered the same idea : If this hypothetical investor were thinking of either investing $1,000 of his $10,000 in the UBS ETRACS 2X Leveraged Long Wells Fargo Business Development Company ETN ( BDCL) and keeping $9,000 in the money market fund, or investing $2,000 of his $10,000 in the UBS ETRACS Wells Fargo Business Development Company ETN ( BDCS) and keeping $8,000 in the money market fund, either choice would entail the same amount of risk and potential capital gain. This is because BDCL, being 2X leveraged, would be expected to move either way twice as much as a basket of Business Development Companies, while BDCS would move in line with a basket of Business Development Companies. This article seeks to analyze whether it is possible to “build your own ETF” with the suite of UBS 2x leveraged ETNs, by applying the strategy described above by Dane Van Domelen and Lance Brofman. Interestingly, the analysis reveals the potential to add on additional yield to your portfolio. Considering fees The fee required to maintain the 2x leverage of the ETRACS 2x ETNs is based on the 3-month LIBOR, which currently stands at 0.33%. This is added to a variable financing spread (0.40-1.00%) to generate a total financing rate that is passed on to investors. This total financing rate of 0.77-1.33% is much lower than is available for all but the wealthiest of individual investors. Lance Brofman writes : Many retail investors cannot borrow at interest rates low enough to make buying BDCS on margin a better proposition than buying BDCL. This means that from an interest 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. Applying the strategy However, what if the investor wasn’t interested in using leverage in the first place? Can he still make use of the low financing rates charged by the ETRACS 2x ETNs? To explore this, let’s try to apply the strategy described above by Dane Van Domelen and Lance Brofman, which basically entails replicating a 100% investment in a 1x fund with a 50% investment in the corresponding 2x fund and a 50% allocation to cash or a risk-free asset. The following illustrates such an example. Example Let’s say that you had $10K invested in the SPDR Dividend ETF (NYSEARCA: SDY ). SDY charges 0.35% in expenses, which comes out to $35 per year. You could replicate that investment with $5K in the UBS ETRACS Monthly Pay 2x Leveraged S&P Dividend ETN (NYSEARCA: SDYL ), leaving yourself with $5K in cash. SDYL charges 1.01% in total expenses, which on $5K comes out to $50.50. In other words, you’d be paying an extra $15.50 per year if you decided to invest $5K in SDYL compared to $10K in SDY. But wait! You have an extra $5K in cash left over. If you can use that $5K to earn $15.50 per year, corresponding to a rate of return [RR] of 0.31%, you can break even. With any higher rate of return, you would benefit from using the leveraged ETN and investing the rest of your cash. At first glance, it seems that 0.31% is a ridiculously low hurdle to surpass, suggesting that one would nearly always benefit from using the leveraged ETNs and investing the rest of the cash. However, one also needs to consider the risk of the invested cash portion. To mimic, as closely as possible, the risk of the original scenario (i.e. $10K invested in SDY), the $5K cash left over after investing $5K in SDYL should be invested in as risk-free of an asset as possible. Bankrate.com shows that 1.30% 1-year CDs and 1.25% savings accounts are currently available. These investments are insured by the FDIC, and can be considered to be nearly risk-free. Using the above example, investing $5K at 1.30% for one year yields you $65.00. After subtracting the additional $15.5 required for the additional expenses of SDYL ($50.50) vs. SDY ($35), you’d gain $49.50, or an additional 0.495%, from using this strategy! Results The following table shows a list of 2x leveraged ETNs, their corresponding 1x fund, and their respective total expense ratios [TER]. Also shown is the rate of return [RR] required on the risk-free portion to break-even, as well as additional yield that you would be able to obtain on the entire portfolio had the risk-free portion been left in cash paying 0%, a savings account paying 1.25% or a 1-year CD paying 1.30%. A negative number indicates that this strategy would lose money relative to investing the whole portion in the 1x fund. The funds are arranged in descending order of required RR on the risk-free portion. Please see my previous article if further information is required regarding these 2x ETNs. Note that some funds such as the ETRACS Monthly Pay 2xLeveraged US High Dividend Low Volatility ETN (NYSEARCA: HDLV ) and the ETRACS Monthly Pay 2xLeveraged U.S. Small Cap High Dividend ETN (NYSEARCA: SMHD ) so not have corresponding 1x counterparts, so are excluded from this analysis. Ticker TER Ticker TER Required RR Cash (0%) Savings (1.25%) 1-year CD (1.30%) ETRACS Monthly Pay 2xLeveraged MSCI US REIT Index ETN (NYSEARCA: LRET ) 1.96% Vanguard REIT Index ETF (NYSEARCA: VNQ ) 0.10% 1.76% -0.88% -0.26% -0.23% UBS ETRACS Monthly Reset 2xLeveraged S&P 500 total Return ETN (NYSEARCA: SPLX ) 1.56% SPY 0.09% 1.38% -0.69% -0.07% -0.04% ETRACS Monthly Reset 2xLeveraged ISE Exclusively Homebuilders ETN (NYSEARCA: HOML ) 1.96% ETRACS ISE Exclusively Homebuilders ETN (NYSEARCA: HOMX ) 0.40% 1.16% -0.58% 0.05% 0.07% ETRACS 2xMonthly Leveraged S&P MLP Index ETN (NYSEARCA: MLPV ) 2.26% iPath S&P MLP ETN (NYSEARCA: IMLP ) 0.80% 0.66% -0.33% 0.30% 0.32% SDYL 1.01% SDY 0.35% 0.31% -0.16% 0.47% 0.50% UBS ETRACS Monthly Pay 2x Leveraged Mortgage REIT ETN (NYSEARCA: MORL ) 1.11% Market Vectors Mortgage REIT Income ETF (NYSEARCA: MORT ) 0.41% 0.29% -0.15% 0.48% 0.51% UBS ETRACS Monthly Pay 2x Leveraged Dow Jones Select Dividend Index ETN (NYSEARCA: DVYL ) 1.06% iShares Select Dividend ETF (NYSEARCA: DVY ) 0.39% 0.28% -0.14% 0.49% 0.51% UBS ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN (NYSEARCA: CEFL ) 1.21% YieldShares High Income ETF (NYSEARCA: YYY ) 0.50% 0.21% -0.11% 0.52% 0.55% UBS ETRACS Monthly Pay 2X Leveraged Dow Jones International Real Estate ETN (NYSEARCA: RWXL ) 1.31% SPDR Dow Jones International Real Estate ETF (NYSEARCA: RWX ) 0.59% 0.13% -0.07% 0.56% 0.59% UBS ETRACS Monthly Pay 2xLeveraged Wells Fargo MLP Ex – Energy ETN (NYSEARCA: LMLP ) 1.76% UBS ETRACS Wells Fargo MLP Ex-Energy ETN (NYSEARCA: FMLP ) 0.85% 0.06% -0.03% 0.60% 0.62% UBS ETRACS Monthly Pay 2xLeveraged Diversified High Income ETN (NYSEARCA: DVHL ) 1.56% UBS ETRACS Diversified High Income ETN (NYSEARCA: DVHI ) 0.84% -0.12% 0.06% 0.69% 0.71% UBS ETRACS 2x Leveraged Long Alerian MLP Infrastructure Index ETN (NYSEARCA: MLPL ) 1.16% UBS ETRACS Alerian MLP Infrastructure Index ETN (NYSEARCA: MLPI ) 0.85% -0.54% 0.27% 0.90% 0.92% BDCL 1.16% BDCS 0.85% -0.54% 0.27% 0.90% 0.92% From the table above, we can see that the LRET/VNQ combination would be the worst pair to implement this strategy with, as it requires a 1.76% RR to break even. This means that even with a 1-year CD rate of 1.30%, you would be losing -0.23% using this method. This can be attributed to LRET’s exceptionally high expense ratio of 1.96%, and VNQ’s exceptionally low expense ratio of 0.10%, making it highly expensive to replicate 100% VNQ with 50% LRET. At the other end of the spectrum, the BDCL/BDCS combination appears to be the best pair for this strategy. The required RR is negative 0.54%, meaning that even if you left the 50% risk-free portion in cash, you would be gaining 0.27% on your overall portfolio. Investing the risk-free portion is a 1-year CD improves the performance of the portfolio by 0.92%. This can be attributed to BDCL’s below-average expense ratio of 1.16% and BDCS’ above-average expense ratio of 0.85%. The following chart shows the required RR for the 2x funds in order to implement this strategy. The following chart shows the additional yield that can be harvested by investing the 50% risk-free portion in cash (0%), a savings account (1.25%) or a 1-year CD (1.30%) for the respective 2x funds. Risks and limitations The 50% investment in a 2x fund may not correspond exactly to a 100% investment in 1x fund. It may do better or it may do worse. Periodic rebalancing may help, but this would entail additional transaction fees. In the case where the 1x fund is an ETF, you are additionally exposed to the credit risk of UBS when it is substituted for a 2x ETN (see introduction). In the case where the 1x fund is an ETF, the tax treatment may change when it is substituted for a 2x ETN. Savings accounts and CDs are only FDIC-insured up to a certain value (though if we’re worrying about this we have much bigger problems on our hands than the implementation of this strategy!). Conclusion A previous article showed that the ETRACS 2x ETNs did not inexorably decay in value even over several years, suggesting that the funds can function as efficient long-term investments for the leverage-seeking investor. This article shows that an investor not interested in leverage could still potentially benefit from the ETRACS 2x funds by “building his own ETF”. This simply costs of replicating a 100% investment in a 1x fund with a 50% investment in the corresponding 2x fund, and a 50% investment in a risk-free asset. Additional yields of up to 0.92% per year are available using this strategy. Further enhancements in yields can be achieved by investing the 50% into more risky assets such as corporate bonds, although this alters the overall risk-reward dynamics of the strategy.