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The ETRACS Monthly Pay 2x Leveraged US Small Cap High Dividend ETN (NYSEARCA:SMHB) is an exchange traded note issued by UBS that provides 2x exposure to an index of small cap high yielding equities.
Investing in SMHB is like gambling at a casino; although it is possible to win a lot of money in a short period of time, over the long run, investors are almost guaranteed to face a ‘Loss Rebalancing Event’ and permanently impair their principal. I would avoid this product.
Fund Overview
The ETRACS Monthly Pay 2x Leveraged US Small Cap High Dividend ETN is an exchange traded note (“ETN”) offered by UBS that is designed to provide 2x the returns of the Solactive US Small Cap High Dividend Index (“Index”).
Index Design
The index is designed to track the performance of 100 small cap companies selected from a universe of qualifying U.S. securities. To construct the index, first, the 3,000 largest companies listed on the NYSE and the NASDAQ are ranked by market cap, from which the top 1,000 are then excluded. Then, any company that has market capitalization less than $100 million, average daily trading value less than $1 million, or has not paid a cash dividend in the past year are excluded.
At this point, the 200 largest companies are selected to form a ‘Primary Selection Pool’. Securities in the Primary Selection Pool are ranked by forward distribution yield, defined as the Thomson Reuters IBES distribution estimate divided by the security’s current price, and the top 100 securities are selected for index inclusion. Securities selected for the index are weighted by their 3-month average daily traded value, with index weights capped at 5% and excess weights redistributed.
The SMHB ETN pays a variable monthly coupon linked to the leveraged cash distributions of the underlying index constituents. If the index constituents do not pay a distribution, then investors will not receive any coupons on the SMHB ETN.
What Is An ETN?
An ETN is an unsecured debt security issued by an investment bank (in the case of SMHB, the issuer is UBS) that tracks an underlying index and trade on a major stock exchange like a stock. At maturity, the ETN will pay the return of the index it tracks, less any fees.
ETNs differ from ETFs in that an Exchange Traded Fund owns a portfolio of securities, whereas an ETN simply provides investors with returns of the underlying index and does not confer ownership of the securities. As a result, investors in ETNs are exposed to the risk that the issuer may default and not honour the contractual total return payout (although this risk is typically very small).
Portfolio Holdings
As noted above, The SMHB is an ETN so it does not actually hold a portfolio of securities. However, from the latest fact sheet, we can see the constituents of the underlying index that is tracked by SMHB.
Figure 1 shows the top 10 holdings of the index, comprising 54% of the index.
Figure 1 – Top 10 index weights of SMHB’s underlying index (etracs.ubs.com)
Figure 2 shows an industry breakdown of the index. Since the index focuses on the highest yielding small cap securities, it is dominated by high yielding REITs which comprise 49.3% of the index. Investment firms (8.5%), diversified retail (6.6%), food and tobacco (5.2%) and textiles and apparel (4.9%) round out the top 5 industries.
Figure 2 – Industry weights of SMHB’s underlying index (Author created with data from SMHB factsheet)
Returns
Figure 3 shows the SMHB ETN’s historical returns. Average annual total returns have been poor for this product, with 1 and 3Yr returns of -36.3% and -15.1% respectively to December 31, 2022.
Figure 3 – SMHB historical returns (morningstar.com)
Annually, we can see SMHB’s returns have been extremely volatile, ranging from -43.0% in 2020 to 8.2% in 2021 (Figure 4). YTD 2023, SMHB has returned 24.4% to January 26, 2023.
Figure 4 – SMHB annual returns (morningstar.com)
Distributions & Yield
The SMHB ETN has paid a trailing 12 month coupon / distribution of $1.54 or a yield of 19.3%. Note that due to the ETN’s poor returns in 2020, the annual distribution was cut significantly, from $3.48 in 2019 to $1.37 in 2020 (Figure 5).
Figure 5 – SMHB’s distribution was cut significantly in 2020 (etracs.ubs.com)
Fees
The SMHB ETN charges an accrued tracking fee of 0.85% (this is similar to a management fee) in addition to accrued financing charges associated with the leverage of the product.
The financing charge is 3M LIBOR + 0.8%. Given 3M LIBOR is now 4.81%, the financing charge is currently a steep 5.61% (Figure 6).
Figure 6 – 3M Libor has soared to 4.81% (tradingeconomics.com)
SMHB Underperforms Index Due To Loss Rebalancing Events
Looking at SMHB’s underlying index, we can see it has delivered annual returns of -1.2% p.a. on a 3Yr basis (Figure 7).
Figure 7 – SMHB’s underlying index historical returns (etracs.ubs.com)
However, from figure 3 above, we see the SMHB ETN has returned -15.1% p.a. on a 3Yr basis. Why is there such a big discrepancy between the two results?
Part of the reason for SMHB’s underperformance is the tracking fee and financing charge mentioned above. However, I believe a larger part of the issue is how the ETN is structured.
Going through the ETN’s prospectus, we can see the ETN’s performance is calculated using an ‘Index Factor’ (Figure 8).
Figure 8 – SMHB monthly returns calculation (SMHB prospectus)
In normal circumstances, the ETN’s Index Factor is 1 + (2 x Index Performance Ratio), which appears straightforward given the ETN’s 2x leverage. However, reading the fine print, investors need to be aware of something called a ‘Loss Rebalancing Event’.
According to the prospectus:
A “Loss Rebalancing Event” occurs if, at any time, the Intraday Index Value on any Index Business Day (other than an Excluded Day, as defined herein) decreases 20% in value from the previous Monthly Initial Closing Level or Loss Rebalancing Closing Level, whichever is more recent.
When a Loss Rebalancing Event occurs, the ETN will reset the then-current leverage to 2.0x. This means that after a Loss Rebalance Event occurs, a constant percentage increase in the index will have less of a positive effect than before the event.
Numerically, assume the ETN begins the month at 100 and the underlying index is also at 100. Let say after 5 business days, the underlying index has lost 10% of its value to 90. This means the SMHB is now trading at 80, and a Loss Rebalancing Event has occurred. From then on, even if the index rallies back to 100 (11.1% return) by the end of the month, the end of month value of the ETN is actually 97.77 = (80 x (1+2 x 11.1%)) and not 100.
Over the long run, there will inevitably be bad months where the index falls more than 10% over a short period of time (market panics and crashes every few years). So investors in the SMHB ETN end up crystallizing losses at inopportune times.
Investing in the SMHB ETN is like gambling in a casino; the longer one plays, the more likely one will lose money. The longer one stays invested in SMHB, the more likely one will experience a Loss Rebalancing Event that will permanently impair one’s principal. Therefore, the best way to win is to avoid playing altogether.
Conclusion
In summary, the SMHB ETN provides 2x exposure to an index of small cap high yielding equities. Although the ETN pays a very high distribution (19.3% trailing 12 month yield), and gives investors an opportunity to earn a very high return in a short period of time (the ETN returned 68.2% in 2021), long-term investors are almost destined to face a ‘Loss Rebalancing Event’ and experience a permanent impairment of their principal. I would avoid this product.
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