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ETF News And Commentary

Thanks to ultra low yields, investors were forced to look to equities for their current income needs. While dividend-focused investments in sectors like staples and utilities were and remain popular, for truly outsized payouts many have looked to the mortgage REIT market instead.

Securities in this segment are among the highest yielders in the equity world thanks to their combination of leverage and real estate holdings. In a nutshell, companies in this space obtain loans and then utilize that capital for real estate investments. But since they are still REITs, they must pay out at least 90% of their earnings to holders in order to obtain favorable tax treatment (see The Guide to 10 Great ETFs Yielding 7% or More).

With this focus, many mREITs pay out double digit yields, crushing broad Treasury bond markets and other dividend payers quite handily in the process. While they can also be quite volatile thanks to  some serious interest rate risk and a declining spread thanks to yield compression, they have been decent performers thanks to a great deal of investors looking for more high yielding securities for their portfolios.

Unfortunately, this was not meant to last as worries over the further compression of the yield in Obama’s second term really pushed mREITs south over the past few weeks. Now that another four years of his Presidency has been assured, many are looking for a continuation of dovish central bank leadership and thus a flatter yield curve.

This situation really hurts mREITs as their entire business depends on a nice spread between their capital borrowed and the rate of return on that money invested. When the rate of return comes down—now thanks to lower ROI on real estate due to Federal Reserve policies—it hampers the profit margin of mREITs.

Since they are using leverage for the most part, any small decrease in profit margins can have an abnormally large impact on their bottom line. So with another few years of dovish policies seemingly assured, it could be a rough time for the space (see Are QE3 and Mortgage REIT ETFs a Winning Combo?).

This trend has sent prices for mREIT shares plunging across the board with broad ETFs targeting the space losing about 7% in the one month period that ended a week after the 2012 U.S. Election. While it should be pointed out that the S&P 500 was down about 4% in the same time frame, the quick drop for the space and the new found pessimism wasn’t exactly great news going forward.

It Really Isn’t That Bad

While the sector may not have the most robust outlook, fiscal cliff worries could actually help the space. That is because mREITs are already taxed at ordinary income so their tax levy will only go up slightly. This compares to a possible tripling of the dividend tax rate which could rise to as much as 44.8% if lawmakers fail to reach a compromise.

If this happens, it will make many other securities with robust payouts far less attractive and once again push mREITs to the forefront of yield oriented investors’ minds. The new taxes could potentially cripple ‘regular’ income plays, push capital back into the mREIT space and help end the sell-off in the market (see Escape the Cliff with These Dividend ETFs).

In fact, we are already seeing somewhat of a rebound in the mREIT market over the past few days as investors are awakening to this reality. After all, mREITs have clearly survived a low yield environment for quite some time; it is hard to see how much more compressed rates could get at this time, suggesting that for investors with a longer time horizon the space could be ripe for investment.

For those looking for a basket approach, there are several mREIT ETFs on the market. Each of the three offer up double digit yields and could be worth a closer look by investors seeking more income without a great deal of tax risk at this time:

iShares FTSE NAREIT Mortgage REITs (REM - ETF report)

This is the most popular mREIT ETF on the market, with just under $850 million in AUM. It is also a very frequently traded one with just under one million shares a day in volume. The ETF charges investors 48 basis points a year, holds about 30 securities in its basket, and tracks the FTSE NAREIT Mortgage REITs Index.

This results in a fund that has over 20% of its assets in Annaly Capital (NLY - Snapshot Report) and then another 16.5% in American Capital Agency Corp (AGNC - Analyst Report), with the rest pretty well spread out among the remaining stocks. Large caps account for just 38% of assets with small caps accounting for pretty much the rest.

Obviously the yield is the real focus of this fund as the 30-Day SEC payout comes in at just under 12.1%. However, the product has also been decent from a price perspective too, as the ETF has added about 8.8% YTD (read Three Impressive Small cap Dividend ETFs).

Market Vectors Mortgage REIT Income ETF

Another decent choice in the mREIT ETF space is Van Eck’s MORT, a product that does quite a bit less in volume but has a respectable $90 million in AUM. The product does charge just 40 basis points a year in fees, although it has about five less firms in its basket thanks to tracking the Market Vectors Global Mortgage REITs Index.

This fund also puts a great deal of assets in NLY and AGNC, although those two, respectively, receive, 18.2% and 14.2% instead. This leaves a bit more for the rest of the mREIT space which results in a slightly more spread out fund. Large caps make up just 33% of this ETF, with the vast majority once again going to small caps.

Yields are impressive in this ETF as well, as the 30 Day SEC payout comes in at 12.15%, just edging out REM in this respect. The fund has also beaten out REM from a price perspective too, as the ETF has added a respectable 10.5% YTD (read 11 Great Dividend ETFs).

ETRACS Monthly Pay 2x leveraged MREIT Index ETN

The newest entrant in the space also tracks the Market Vectors Global Mortgage REIT Index. However, this ETN utilizes two times leverage that resets on a monthly basis for its exposure.

This results in a fund that is very volatile, although it also hopes to be a big yielder. In fact, the expected yield comes in at 24.8% per year, more than enough to make up for the 40 basis point fee per year.

With that being said, investors should note that the product is structured as an ETN so there is some credit risk from UBS, although tracking error will not be an issue. Furthermore, during the recent slump the product lost about 10% of its value, despite having only been on the market for a month.

The ETN does, however, look to be a yield king as there are pretty much no other products out there with a 20%+ yield like this one. So for those truly starved for yield this could be an interesting choice, especially if you have a tolerance for risk and a belief that the mREIT space is due for a rebound.

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