As I mentioned a few posts ago, I’m beginning to change my investment strategy from beaten up stocks to beaten up sectors, this way avoiding the company specific risk that comes with buying one company at a time. As I’ve spent some time looking at ETFs over the past few days, I’ve come to realize the sector specific ETFs aren’t really perfect products. The ETF we’re going to talk about today has underperformed the index for its entire existence, mostly because they cap their exposure to the biggest name in the sector at 20% of the fund. While this is good from a diversification standpoint, it isn’t good from a return standpoint.

The Guts of The Fund

What you need to know about the NAREIT Mortgage Plus Capped Index Fund:

Total Assets: 159M

Expense Ratio: 0.48%

Shares Outstanding: 10,300,000

Total Holdings: 51

Ticker Symbol: REM

Current Price: 15.41

Last Year’s Yield: 9.67%

Obviously, the yield is the most exciting part about this product. But is it sustainable? First, let’s take a closer look at how a mortgage REIT works.

How Mortgage REITs Work

Mortgage REITs borrow money at short term interest rates, and use that money to buy long term mortgage backed securities. Yes, even after the financial crisis, those still exist. As the underlying mortgages get paid, the fund makes money on the cash flow. Because they’re an American REIT, government regulations stipulate that they must pay at least 90% of their income back to unitholders.

Because they’re allowed to retain so little of their earnings, mortgage REITs are constantly coming back to the market for financing or to issue new shares. They need the capital to expand their holdings.

Mortgage REITs currently have very high yields, with some flirting with 20%. This is because of the high amounts of leverage they use, as well as a healthy spread between short term interest rates and long term rates.

Once QE2 is over, the Fed will start selling the mortgage backed securities they bought during the financial crisis. Look for mortgage REITs to buy the majority of those.

A Closer Look At The Holdings

One of the problems with this product is it isn’t really a mortgage REIT ETF. There just aren’t enough of them to build a fund around. So the fund also holds shares of banks that are heavily exposed to mortgages. Close to 30% of the fund is invested in banks, which doesn’t make it a true REIT fund. These bank holdings also don’t pay as big of dividend as the mortgage REITs, which drags down the yield of the whole fund.

21% of the funds’ holdings are invested in one company, Annaly Capital Management. While Annaly’s 13% yield helps bring the fund’s dividend up, the fund is still somewhat vulnerable to one company and their specific risks. This is a bit of a downfall for someone who is looking to avoid company specific risk by buying an ETF.

Contrarian Territory

This bad boy is definitely a contrarian play. It invests in mortgage REITs and regional banks with large exposure to mortgages. Both of these sectors have been beaten down something fierce over the last couple of years.

The ETF did spend a few years above the $30 level, but that was during the largest housing boom in history, so I’m not sure that’s a realistic target for the fund. While it is up close to 50% from the March 2009 lows, I can see additional upside as the housing market comes back into favor, maybe in the 50% range over the course of 2-3 years. That, combined with the generous yield, could make this fund an interesting investment.

Or, spiraling inflation could cause the fed to aggressively raise rates, making this a horrible place to be. If that happens, I might cry.

Will I Buy It?

Maybe.

How’s that for certainty?

 

 

Tell everyone, yo!