After the implosion of a couple of leveraged MLP exchange-traded notes (“ETNs”) last month, I noticed that many investors are not aware of the anti-ruination triggers that are embedded in many leveraged products.
When the first leveraged mutual funds and ETFs arrived on the scene, they all reset their leverage exposure on a daily basis. As a result, the long-term performance of a 2X product did not equal 200% of an unleveraged fund tracking the same index. Whenever leverage is reset, the longer-term performance becomes path-dependent. This became much clearer during the financial crisis, when many banking and financial stocks lost money, the 2X financial ETFs lost money, and even the 2X inverse financial ETFs lost money. To be sure, there were many weeks and months when the inverse funds produced hefty gains, but they lost money over the long term due to the daily reset.
Many investors complained about this without fully comprehending the safety features that daily reset provides. For example, let’s use a hypothetical index with a starting value of 100 that loses 20 points a day for the next three days. The index, and an unleveraged ETF tracking it, would see their values drop by 60%, going from 100, to 80, to 60, to 40.
A 2X ETF tracking that same index that does not reset its leverage would see its value drop by 40 points per day, going from 100, to 60, to 20, to -20, which is an impossibility. An investor who bought an unleveraged ETF using margin would be in the hole and be forced to make up the difference. However, going negative with ETFs is not practical, and therefore daily reset became the norm. Instead of having double the “point” change, ETFs with daily reset double the “percentage” change.
Using our same example, the index that loses 20 points a day lost 20% the first day, 25% the second day, and 33.3% the third day. Therefore, the 2X ETF with daily reset lost 40% the first day, then 50%, and 66.6% the last day. If its starting value was 100, then its subsequent values were 60, 30, and 10. The 90% drop from 100 to 10 is certainly devastating, but it is orders of magnitude better than -20. Additionally, with daily reset, the 2X ETF could survive another three days of the hypothetical index dropping 20 points a day. In this case, the 2X ETF would lose another 90%, dropping from 10 to 1, but the index itself would be theoretically negative, and an unleveraged ETF tracking it would be bankrupt.
Some ETF and ETN sponsors tried to appeal to investor demand for leveraged products with long-term performance that more closely tracked a multiple of the underlying index. They introduced products that did not reset their leverage and products that reset monthly instead of daily. Because there is increased probability that the underlying index could decline more than 50% between resets, these products need special termination triggers to prevent their complete ruination (going to zero or below).
Barclays introduced two no-reset products in 2009 that eventually triggered early termination and closure. Last month, two MLP-based ETNs with monthly resets triggered early terminations. The UBS ETRACS 2xMonthly Leveraged Alerian MLP Infrastructure Index ETN (MLPL) triggered a mandatory redemption on January 20 when the underlying index dropped by more than 30% (60% for the ETN) from its most recent monthly closing value. The UBS ETRACS 2xMonthly Leveraged S&P MLP Index ETN (MLPV) triggered a mandatory redemption the same day when its intraday value dropped below $5.00 per unit.
To prevent ETFs and ETNs from going to zero, they must have anti-ruination triggers that will shut them down while they still have some money to distribute to shareholders. In January, amid the rout in MLPs, that is exactly what happened. One was triggered when it fell 60% between resets (before it could fall 100% or more). The other was triggered when its value dropped below $5.00 after originally being offered at $25.00 per unit. Owners lost money, but they did not have to cough up more money like investors receiving margin calls.
Utilities extended its stay at the top to six weeks, and despite being the worst-performing sector this past week, it continues to maintain a large buffer over the rest of the field. A week ago, I commented that the 38-point advantage of Utilities was not sustainable, and we are already seeing that spread dwindle. Telecom moved slightly ahead of Consumer Staples as both posted small momentum improvements. Today is the third week with these three sectors being the only categories in green. Industrials held on to fourth, Materials edged higher to fifth, and Real Estate slipped to sixth. The lower-ranked sectors all posted slight momentum improvements while limiting movement within the rankings. Consumer Discretionary had a strong week, allowing it to move back ahead of Energy and mount a challenge to Health Care and Technology. The Financials sector is on the bottom again.
The style categories all posted momentum improvements. The weaker ones had the strongest bounces, and the spread between top-ranked Mega-Cap and last-place Small-Cap Growth narrowed from 53 to 47 points. Large-Cap Growth and Mid-Cap Value swapped places, producing the only changes in the relative rankings. The change does not affect the shift to Value over Growth that was noted last week, but it does reassert the preference for larger-capitalization stocks over their smaller brethren. From a pattern perspective, Mega-Cap holds a sizeable lead, then there is a linear falloff from Large-Cap Value down to Mid-Cap Growth. Below that, the momentum scores decline more rapidly with Small-Cap Blend, Micro-Cap, and Small-Cap Growth each being successively weaker.
Despite renewed weakness in the Energy sector, Canada kept its grip on first-place honors. Canada is also benefitting from the recent surge in gold and mining stocks, as is second-place Pacific ex-Japan, another resource-rich category. The U.S., Emerging Markets, and World Equity round out the top-five categories, which are all sitting in the same positions as a week ago. The lower portion of the rankings saw some changes with the U.K. moving three places higher to sixth and the Eurozone edging a notch higher. On the downside, Latin America slipped a spot, and Japan fell three places lower. Japan bounced strongly yesterday, but last week’s trading established a new two-and-half-year low. Japan is an excellent example of passive investing not working. The iShares MSCI Japan ETF (EWJ) will be 20 years old next month, and it is currently 13% below its initial value. However, it’s worse than that for many holders of Japanese stocks because the Tokyo Nikkei Index stood at 38,916 in December 1989. Last night, it closed at 15,836, more than 59% below its 1989 peak. Today, it needs to gain another 23,080 points, or more than 145%, just to get back to where it was 26 years ago.
“I have very little tolerance for incompetence.”
—John P. Shaughnessy (~1982)
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