A few months ago, in the midst of the 2020 COVID-19 standstill, I brought up an idea to a friend to short closed-end funds (“CEF”). In particular, I focused on UBS ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN ($CEFL), which is now liquidated by mandatory redemption1. My rationale predicated around the fact that these funds were focused primarily on delivering a distribution (similar to a dividend) to shareholders by investing in equities that had a generous dividend, and that mostly retail investors held shares in these companies. What I will describe in this post is also applicable to most of the UBS ETRACS series of leveraged ETNs including $CEFZ. Leveraged REIT ETNs like $MORL and $MRRL faced a similar fate as described below.
I won’t get into the technical definitions and jargon of a CEF like its distribution rate, detailed tax implications, constructive vs. destructive return on capital, etc. If you were a CEF investor, you were basically paying a fund to do dividend investing for you.
This meant that a huge portion of their assets are in companies such as Carnival Cruise Line ($CCL), Amgen ($AMGN), and various REITs that were large cap companies but had a generous dividend yield.
Unfortunately with the economic standstill in the first half of 2020, most of these dividend-paying companies are now faced with tremendous risk of credit downgrades, slashing dividends, and bankruptcy. In fact, since January of 2020, they had already been in decline2 and by early March, were basically selling whatever was liquid and almost no fund traded at a premium to its NAV3.
I don’t know very many people who invest in closed-end funds. Financially savvy millennials are either in debt, strictly indexing, or managing their own portfolios. Retirement accounts are basically entirely in mutual funds (a market dominated by Vanguard, Schwab, and Fidelity mutual funds). The majority of people holding CEFs were boomers and hedge funds taking advantage of the net asset value (“NAV”) arbitrage.
What is NAV?
NAV, or net asset value, is literally what its name implies: the value of all the assets of the fund. Basically, if you add up all the assets of the fund, the dollar amount should be reflected in the fund’s price per share at any given point right?
It does not! Each individual CEF listed on public exchanges will trade at some premium or discount to its NAV (though usually discount for taking into account management fees). This is where the price arbitrage comes in. If you were a market neutral hedge fund and you want to profit off the (usually short term) mispricing, you might, for example, short the fund itself if it trades at a premium to NAV and go long its assets (pair trade), or vice versa.
How the economic sudden stop impacts CEFs
Now that we’ve established that CEFs are primarily held by boomers and hedge funds, let’s investigate what makes $CEFL so weak. If you’re a boomer and the market is collapsing around you and you might even die. Are you going to hold $CEFL or any CEF? How about the hedge fund who’s seeing equities collapse everywhere? Are they going to hold CEFs and try to arbitrage CEFs vs. equities on the way down? No! In fact, funds that took on leverage have been blowing up left and right so badly they’re even selling gold and treasuries. What about dip buyers? I hear people saying they’ll buy the dip on airlines and Boeing ($BA). I don’t hear people saying they’re buying the dip on a CEF, the funds are too abstract and far removed from the underlying.
So you have a compounding effect of weak equities at risk of cutting dividends. Already weak, leveraged CEFs that will plummet more as their NAV drops and more people sell their CEF shares. This will create a terrible effect that will widen the spread between CEFs’ price per share and NAV, and this is exactly what happened.
Consider the above chart of the AllianzGI Dversified Income & Convertible Fund $ACV. This is the quintessential NAV arbitrage fund where its NAV and price periodically fluctuates between discount and premium. Now example how much it collapsed relative to its underlying during the late-Feb/Mar market crash.
The above chart presents a similar view. The fund has been steadily declining relative to NAV (likely due to fund outflows). Most notably, observe the volatility its facing vs. its underlying assets (which remained surprisingly stable). If I had to guess, this fund is extremely leveraged.
And yet there are some (well respected) funds such as Gabelli (above) that have consistently traded at a premium to NAV and even continued using leverage during the 2020 crash and bounce/retracement. Its actual assets and performance relative to S&P will not be discussed here.
But there’s something special about $CEFL that really takes the cake. $CEFL is a 2x leveraged “monthly pay” ETN, meaning that it’s leveraged and had to meet its dividend payment monthly! As if there wasn’t enough against it, those who have dug into $CEFL’s holdings have noted that it has a pretty bad track record due to blindly investing in CEFs7. $CEFL was layers upon layers of derivatives all collapsing.
Like several other leveraged ETFs, $CEFL went down hard, falling from $20 in February to $12 when I took a serious look to $2.81 and being delisted on March 27. By the time it was $2.81, the dividend yield was over 98% (I believe over 100% at some point but I don’t have that documented). The ETN was basically paying its entire market value very year. I haven’t lived through many financial crises, but this is one for the books.
In conclusion, stay away from these risky leveraged ETNs with incredible dividend yields, especially during times of downward momentum. It was evident that many CEFs were leveraged, held shaky assets, and the average CEF holder wasn’t going to hold when they’re down 10-15% with risk of dividends getting cut. During sudden financial stops, profits vanish and high dividend equities will have to slash dividends as profits evaporate. $CEFL can only be described as a tragedy where all things went wrong. Even though the $CEFL ETN was liquidated, investors are claiming they weren’t compensated properly (NAV of ~$5.40 vs. ~$3.61 or something) and now a few opportunistic law firms are taking advantage of this8 9 10 11.