SMHB - SMHB 2X ETN Shows Yield Chasing Can Be Expensive

Summary

• The ETRACS Monthly Pay 2x Leveraged US Small Cap High Dividend ETN seeks to track twice the monthly performance of the Solactive US Small Cap High Dividend Index.
• Investors fared better with the Vanguard Small-Cap ETF, a passive SC ETF invested in the CRSP US Small Cap Index.
• Both "funds" are reviewed and compared. I believe readers will then see why I picked the title I did. Stick to the basics, sell SMHB!

(This article was co-produced with Hoya Capital Real Estate )

Introduction

As a retired investor, I have different goals for different accounts, as probably many non-retired investors do also. For my bill paying and IRAs with RMDs due, I lean to generating enough income so I only have to sell a position when I want to, not when I need the cash. While RMD's do allow for in-kind transfers, we use QCDs instead and that option is not available for that withdrawal method. For these accounts, owning an asset like the ETRACS Monthly Pay 2x Leveraged US Small Cap High Dividend ETN ( SMHB ) was considered but rejected because, in the end, Total Return wins over a generous yield. To demonstrate this, I compare what SMHB has done against one of the largest, most popular Small-Cap ETFs, the Vanguard Small-Cap ETF ( VB ). My suggestion is stick to the basics!

Leveraged asset warning: Leverage ETFs and ETNs have some major shortcoming which make them poor long-term investments such as high fees, cost of futures, and the fact the X-factor applies to each time period of the ETF, mostly daily. Long-term investors seldom (if ever) earn the X-factor and this is plainly seen in the above chart. Two good resources on these assets are:

• Seeking Alpha article: Leveraged ETFs: What They Are & How They Work
• FINRA's article: Lowdown on Leveraged and Inverse Exchange-Traded Products

ETN warning: Exchange-Trade-Notes come with another risk leverage ETFs do not necessarily have; issuer default risk. Here is a brief description for those who haven't heard about this instrument:

ETRACS Monthly Pay 2x Leveraged US Small Cap High Dividend ETN review

Seeking Alpha describes this ETN as:

SMHB seeks to provide a two times leveraged return linked to the compounded monthly performance of the Solactive US Small Cap High Dividend Index . The index is designed to measure the performance of 100 relatively small capitalization, dividend yielding index constituent securities selected from a universe of qualifying U.S. listed equity securities. The Securities are two times leveraged with respect to the index. SMHB started in 2015.

Source: seekingalpha.com SMHB

SMHB has just $33m in AUM and the managers charge 85bps in fees. The payout is erratic, with the TTM yield over 19%. UBS may elect to redeem all outstanding ETNs at any time on or after November 15, 2019, as they have some of their other ETNs.

Index review

The Solactive US Small Cap High Dividend Index is intended to track the price movements of stocks which are publicly traded on US stock exchanges and fulfill certain minimum requirements in terms of market capitalization. From this universe, the stocks with high Forward Looking Distribution Yield.

Source: etracs.ubs.com SMHB Factsheet

The Methodology PDF adds to that description.

• The Indices are calculated and distributed by Solactive AG.
• Universe selection rules :
  • Stock must trade and the company domiciled in the United States.
  • Rank the 3,000 largest companies according to share class Market Capitalization that fulfil the above, plus liquidity rules, and then select the 2,000 smallest such companies.
  • The entity has paid at least one ordinary cash dividend in the last 12 months as determined by the annual dividend yield and not announced a discontinuance of ordinary dividends.
• Ranking : Forward Looking Distribution Yield: The 100 entities with the highest ranks in accordance with their Forward Looking Distribution Yield are advanced to the next step. For clarification: The higher the Forward Looking Distribution Yield the higher the rank.
• Weighting: The constituents are weighted based on their trailing 3 month average daily value traded across all U.S. exchanges ("ADV"). Each constituent is capped at a 5% weight with any excess weight distributed to the other constituents on a pro rate basis as determined by ADV. If after re-distributing the weight of a constituent would exceed the 5% weighting, the re-distribution process is done iteratively until all constituents are below 5% weighting in the index as of the Selection Day.

SMHB Holdings review

The only holding is the ETN itself. UBS provides this description:

The ETRACS Monthly Pay 2xLeveraged US High Dividend Low Volatility ETN Series B is designed to provide 2 times leveraged long exposure to the compounded monthly performance of the Solactive US Small Cap High Dividend Index, less financing costs and tracking fees, and may pay a variable monthly coupon linked to the leveraged cash distributions associated with the underlying index constituents. Note that if the index constituents do not make distributions, then investors will not receive any coupons.

Exchange-traded Notes are senior, unsecured, unsubordinated debt securities that provide investors with exposure to the total returns of various market indices, including those linked to stocks, bonds, commodities and/or currencies, less investor fees. ETRACS offers innovative investment products with easy access to markets and strategies that may not be readily available in the existing marketplace.

Source: etracs.ubs.com SMHB snapshot

For greater details, there is a Prospectus available.

While I did not find what the ETN holds, the Index does report its composition, with these stocks comprising the Top 20 holdings.

With only 100 stocks in the Index, SMHB is more concentrated than VB, with its almost 1500 stocks.

SMHB distribution review

While SMHB has existed since 2015, the first payout did not occur until 12/2018, and has been monthly since. The large payouts at the start could be releases of income built up over the first few years, but that is pure speculation on my part. Seeking Alpha does not provide a dividend scorecard for SMHB. One question I know readers will ask and I cannot clearly answers is about taxes. The SMHB Prospectus takes five pages in legalese to cover that topic.

Vanguard Small-Cap ETF review

Seeking Alpha describes this ETF as:

The Vanguard Small-Cap ETF invests in growth and value stocks of small-cap companies across multiple sectors. The fund seeks to track the performance of the CRSP US Small Cap Index . VB started in 2004.

Source: seekingalpha.com VB

VB has $44b in AUM and has a meager yield of 1.43%. Vanguard charges 5bps in fees.

Index review

CRSP describes their index as:

The CRSP US Small Cap Index includes U.S. companies that fall between the bottom 2%-15% of the investable market capitalization. There is no lower limit in market capitalization, other than what is specified by investability screens. Reconstitution occurs quarterly after the market close on the third Friday of March, June, September, and December.

Source: crsp.org/indices

Important data points include:

• LARGEST COMPANY: $17,221m
• SMALLEST COMPANY: $18m
• MEDIAN COMPANY: $2,168m
• AVERAGE COMPANY: $2,952m
• NUMBER OF COMPANIES: 1,471
• WEIGHT LARGEST COMPANY: 0.40%

For more information on CRSP index construction, they provide a Methodology PDF .

VB holdings review

Sector allocations are:

Like its Large-Cap cousin, two of VB's top sectors are Technology and Financials, though the allocations are smoother than what one might see in those LC ETFs. Vanguard list holdings using Industry designations, with the Top 20, out of 1491 stocks, accounting for just 6.4% of the portfolio.

VB distribution review

Like most ETFs, VB makes a payout quarterly, unlike the UBS ETN which currently has a monthly distribution. Seeking Alpha grades these results as a "A-".

ETFs compared

Right out of the starting gate, SMHB underperformed compared to the VB ETF. The pain of a 2X really showed during the COVID market collapse in early 2020.

Using a 2X strategy, one might expect the StdDev to be twice that of a standard Small-Cap ETF. In reality, it is almost 3 times as large! I have to say I am surprised that the Sharpe and Sortino ratios are as close as they are.

Portfolio strategy

For investors who like the Exchange-Traded-Notes concept, the UBS sponsored ETRACS series has over 70 to pick from, many designed for enhanced income generation. If so, be sure you analyze the strength of the UBS Group AG ( UBS ).

In my view, use different investments for equity returns and income generation in the Small-Cap arena. It shows the same lack of performance compared to a popular Small-Cap dividend ETF, the WisdomTree U.S. SmallCap Dividend ( DES ). Or venture into a CEF like the Royce Value Trust ( RVT ). This how SMHB and VB compare to these two funds.

For further details see: