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Top Three Mortgage Finance ETFs

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After enduring overwhelming recessionary shocks, the U.S mortgage finance industry has gradually started recovering. Favorable economic data coming in domestically and from abroad has resulted in an increase in corporate activities leading to higher income and consumption in the U.S markets.

As the demand for residential and commercial real estates rises, likewise mortgage financing companies are bound to see an increase in their asset books in the near future (read Time For A Commercial Real Estate ETF?). While this is favorable for the overall economy, care has to be taken in order to prevent another housing bubble like in 2008.

With stringent risk management principles in place (like the ones in Basel I, II and III) and the complex-derivative instruments relating to mortgage financing (Mortgage back securities, Collateralized Debt Obligation, asset-backed securities etc.) being highly regulated post-2008 debacle, the solvency and credit quality of the mortgage financing companies and their loans have improved immensely.

One of the major players in the mortgage finance industry is Real Estate Investment Trusts (REITs). REITs are companies that finance, own and operate real estate properties. They raise capital from retail as well as institutional clients and pool the raised capital to purchase mortgage securities from the market.  The returns thus generated from these investments are paid back to the investors in the proportion of their capital contribution. (read Top Three High Yield Financial ETFs)

Investing directly in real estates involve large capital commitments. However, mortgage REIT ETFs have been attracting institutional as well as retail investors throughout the past decade as a cost effective way to invest in real estate as an asset class, which is known to generate solid returns over the long term.

However, investing in mortgage finance ETFs have their own risks which can impact prices of this sector going forward. This could be especially true if the economy slowly begins to recover and if interest rates continue to move higher.

Interest rate risk results in fluctuations in the value of mortgage REIT investments due to changes in benchmark rates. Since interest rates and prices of mortgage securities are inversely related, the investments go down in value if general interest rates increase and vice versa when rates are slumping.

Credit risk is the risk that arises when the mortgage borrower fails to honor his payment obligation. When this situation arises, the market values of the REITs are adversely impacted as non payment increases the probability of insolvency and write-downs (read Capital Markets ETFs For 2012?).

Prepayment Risk arises when the borrower pays the loan off before the in advance. This generally happens in a decreasing interest rate scenario as the borrower decides to pay off a loan in hopes of getting a new one at a lower rate. This results in a notional loss for the financing company thereby reducing the value of investments as it ends of costing the company future coupon payments.

Leverage Risk arises when the REITs borrow extra money from the market by keeping their securities as collateral. This is done in order to earn a higher amount of profits by capitalizing on the differences in interest rates across shorter and longer ends of the yield curve. On the contrary when interest rates go down, this magnifies the losses for these companies (read EUFN: The Best ETF For The Euro Crisis).

Despite these risks, there are still several reasons why mortgage finance firms could make for a compelling investment. Real estate demand is finally starting to turn around and prices for many REITs could surge as a result.

In fact, sales of existing homes in February marked the best second month of the year for the industry since before the market crash. Additionally, investors also saw the first year-over-year price increase in home values since November of 2010.

If these trends continue, and if interest rates remain low, it could give some REITs pricing power in many market segments. This could be especially true in robust markets where there isn’t very much oversupply to begin with, a situation that could help to boost the sector.

For investors looking to make a play on the broad space, there are several options in the ETF world. These ETFs employ a basket approach of investing across various mortgage finance firms, ensuring that company specific risk is pretty much entirely diversified away. As a result, any of the following three ETFs could be great picks in this slowly recovering market:

Market Vectors Mortgage REIT ETF (MORT)

For investors looking at a high yielding equity income fund in the mortgage finance space, MORT is an interesting option. The fund tracks the price and yield performance of the 24 securities listed in Market Vectors Global Mortgage REITs Index before fees and expenses.

The capitalization weighted index tracks the overall performance of publicly traded mortgage REITs globally. MORT charges investors net expenses of 40 basis points a year.

The fund holds 72% of its total assets in its top 10 holdings and relies heavily on Annaly Capital Management Inc, (NLY) its top holding (18.66%). The ETF was launched by Market Vectors in August of 2011, and since then it has obtained a promising $ 23.6 million in its asset base.

The fund pays out a solid yield of 10.84%. MORT gives very good exposure throughout all levels of market capitalization, but employs a core value style of investing as indicated by its low P/E multiple of 7.33. To sum up, steady flow of income backed with potential of long term capital appreciation is the backbone of this particular fund.

iShares FTSE NAREIT Mortgage Plus Capped ETF (REM)

Launched in May of 2007 by iShares, REM is one of the oldest and better performing ETFs in the mortgage finance space with over $278 million worth of total assets under management.

The passively managed ETF tries to replicate as closely as possible the price and yield performance of the FTSE NAREIT All Mortgage Capped Index. The index measures the performance of the residential and commercial mortgage real estate sector of the U.S equity market.

The fund employs a value style of investing and holds a total of 28 securities in its portfolio, charging investors an average 48 basis points per annum in fees. The fund holds 73% of its net assets in its top 10 holdings and pays out a whopping annual yield of 11.13%

SPDR S&P Mortgage Finance ETF (KME)

This fund looks to resemble S&P Mortgage Finance Select Industry Index before fees and expenses. The index is derived from the mortgage financing, processing and marketing segment of the U.S equity market. The components of the index have an average EPS growth of 9.2%.

However, the fund does not lay much emphasis on current income as indicated by its dividend yield at 2.93% per annum. Although the fund holds only 45 securities in total, just 25.28% of its total assets are in its top 10 holdings thereby offering investors a very well diversified portfolio (read Three ETFs With Incredible Diversification).

The fund charges a paltry 35 basis points in fees and expenses making it a low cost choice in this space, especially when compared to its more real estate focused peers on this list.

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