Why You Should Shy Away From Leveraged Dividend ETNs [WisdomTree SmallCap Dividend Fund (ETF)]

Wall streetDavid Fabian: UBS just launched their latest leveraged exchange-traded note (ETN) designed to capitalize on the opportunities in small cap dividend stocks. By my count, that now makes four diversified investment vehicles in the UBS product suite that are geared towards common equity dividend paying indexes with an underlying leverage component.

The long-titled ETRACS Monthly Pay 2xLeveraged US Small Cap High Dividend ETN (SMHD) is designed to provide monthly compounded 2 times exposure to the Solactive US Small Cap High Dividend Index. In other words –SMHD is an unsubordinated debt instrument designed to provide leveraged exposure to a basket of approximately 100 small capitalization stocks that pay high dividend yields.

According to the UBS ETRACS website, this ETN has an index yield of 17.70% and income is paid monthly to shareholders. In addition, the underlying portfolio leverage is reset monthly instead of daily in order to improve tracking efficiency.

Little bit of leverage, truckloads of monthly income – sounds like fun right?

While I’m all about maximizing dividends given the prevailing interest rate and equity market environment, a vehicle of this nature should really only be appropriate for institutional or aggressive investors. This is not a knock against ETNs, UBS (the fund sponsor) or any aspect of the underlying index – rather it has more to do with taking an appropriate amount of risk for the consummate expected return.

One mantra that income investors should always keep at the forefront of their expectations is that high yield = high risk. There is no such thing as a free lunch when it comes to balancing the spread between a credit-risk free U.S. Treasury bond and a high yield security of any variety.

I have been a staunch advocate of investors shying away from leveraged vehicles of this nature because they magnify price changes in both directions. The majority of investors I come in contact with typically have a conservative or moderate risk tolerance that would make an investment of this nature unsuitable for their needs. They simply wouldn’t sleep well at night knowing that their hard earned nest egg is susceptible to wild swings in value despite the commensurate higher dividend rate.

While not nearly as exciting in terms of leverage or income, the WisdomTree SmallCap Dividend Fund (DES) may make a more suitable alternative for traditional portfolios seeking out a diversified equity-income play. DES has exposure to 737 small and mid-cap companies with histories of paying dividends to shareholders.

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