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 leveraged 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.
Disclosure: Author has no positions in any of the securities mentioned and no positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) is received from, or on behalf of, any of the companies or ETF sponsors mentioned.