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Summary REM has a high expense ratio, but it is superior to new investors picking mREITs simply on trailing dividend yield. The top holdings are fairly similar, but as we move down to the third holding we see some great diversification benefits. When REM “goes on sale” after a period of intense interest rate volatility, it is not really “on sale”. The mREITs within the portfolio suffer severe losses from volatility. Investors should use allocations like REM in a conservative manner to boost the total income on the portfolio. One option many yield starved investors might miss out on is the iShares Mortgage Real Estate Capped ETF (NYSEARCA: REM ). The ETF isn’t perfect, but it does quite a few things right and in my opinion it may be a substantially superior option to investors picking their own mortgage REITs if they do not understand the mortgage REIT business. An enormous portion of my coverage on Seeking Alpha is in the mortgage REIT sector and I’ve seen quite a few investors lose large chunks of money to being heavily invested in individual mREITs without understanding the accounting implications of management’s decisions. If an investor is willing to put in the time to learn the mREITs, I find that superior to the ETF option. If that seems like too much work, REM is an option with a massive 14.4% dividend yield. Expense Ratio The expense ratio on REM is .48%. Largest Holdings (click to enlarge) The holdings are not ideal in my opinion, but they aren’t bad. For the expense ratio, I would expect more investigation of which small cap mREITs are going to be underpriced and which mREITs will excel in the opposite scenarios. Annaly Capital Management (NYSE: NLY ) is a fairly huge Agency mREIT and their portfolio is fairly similar to the second holding, American Capital Agency Corp. (NASDAQ: AGNC ). The biggest difference in these two mREITs at the present time is the structure of their swap portfolios. NLY is hedging farther out on the yield curve and AGNC is using hedges with shorter durations but a higher notional value. If you want to learn more about either, I’ve covered both quite a few times. The nice thing about this portfolio is that it uses Starwood Property Trust (NYSE: STWD ) as the third holding. Starwood Property Trust is a huge REIT with vastly different risk factors from the simple Agency RMBS portfolios of NLY and AGNC. You can see my introduction to STWD . Overall, the portfolio of mREITs will be prone to one major weakness which is volatility in the interest rate environment. Some of these mREITs will benefit more from low rates and some from high rates, but very few mREITs are designed to benefit from volatility in the interest rate environment. If we go into a sustained period of fairly stable interest rates, it would be very bullish for the sector. Dividend Difficulties If there is volatility in the interest rate environment, it can result in very serious damage to both book value and earnings for mREITs which could force them to cut their dividend payouts. If you’re using REM to supplement your retirement, be aware that the dividend could be reduced materially and share prices falling when interest rates are volatile does not necessarily mean that the sector is “on sale”. Building the Portfolio This hypothetical portfolio has a moderately aggressive allocation for the middle aged investor. Only 25% of the total portfolio value is placed in bonds and a fifth of that bond allocation is given to high yield bonds. If the investor wants to treat an investment in an mREIT index as an investment in the underlying bonds that the individual mREITs hold, then the total bond allocation would be 35%. Given how substantially mREITs can deviate from book value, I’d rather consider the allocation as an equity position designed to create a very high yield. This portfolio is probably taking on more risk than would be appropriate for many retiring investors since a major recession could still hit this pretty hard. If the investor wanted to modify the portfolio to be more appropriate for retirement, the first place to start would be increasing the bond exposure at the cost of equity. However, the diversification within the portfolio is fairly solid. Long term treasuries work nicely with major market indexes and I’ve designed this hypothetical portfolio without putting in the allocation I normally would for equity REITs. An allocation is created for the mortgage REITs, which can offer some fairly nice diversification relative to the rest of the portfolio and they are a major source of yield in this hypothetical portfolio. The portfolio assumes frequent rebalancing which would be a problem for short term trading outside of tax advantaged accounts unless the investor was going to rebalance by adding to their positions on a regular basis and allocating the majority of the capital towards whichever portions of the portfolio had been underperforming recently. Because a substantial portion of the yield from this portfolio comes from REITs and interest, I would favor this portfolio as a tax exempt strategy even if the investor was frequently rebalancing by adding new capital. The portfolio allocations can be seen below along with the dividend yields from each investment. Name Ticker Portfolio Weight Yield SPDR S&P 500 Trust ETF SPY 35.00% 2.06% Consumer Discretionary Select Sector SPDR ETF XLY 10.00% 1.36% First Trust Consumer Staples AlphaDEX ETF FXG 10.00% 1.60% Vanguard FTSE Emerging Markets ETF VWO 5.00% 3.17% First Trust Utilities AlphaDEX ETF FXU 5.00% 3.77% SPDR Barclays Capital Short Term High Yield Bond ETF SJNK 5.00% 5.45% PowerShares 1-30 Laddered Treasury Portfolio ETF PLW 20.00% 2.22% iShares Mortgage Real Estate Capped ETF REM 10.00% 14.45% Portfolio 100.00% 3.53% The next chart shows the annualized volatility and beta of the portfolio since April of 2012. (click to enlarge) A quick rundown of the portfolio Using SJNK offers investors better yields from using short term exposure to credit sensitive debt. The yield on this is fairly nice and due to the short duration of the securities the volatility isn’t too bad. PLW on the other hand does have some material volatility, but a negative correlation to other investments allows it to reduce the total risk of the portfolio. FXG is used to make the portfolio overweight on consumer staples with a goal of providing more stability to the equity portion of the portfolio. FXU is used to create a small utility allocation for the portfolio to give it a higher dividend yield and help it produce more income. I find the utility sector often has some desirable risk characteristics that make it worth at least considering for an overweight representation in a portfolio. VWO is simply there to provide more diversification from being an international equity portfolio. While giving investors exposure to emerging markets, it is also offering a very solid dividend yield that enhances the overall income level from the portfolio. XLY offers investors higher expected returns in a solid economy at the cost of higher risk. Using it as more than a small weighting would result in too much risk for the portfolio, but as a small weighting the diversification it offers relative to the core holding of SPY is eliminating most of the additional risk. REM is primarily there to offer a substantial increase in the dividend yield which is otherwise not very strong. The mREIT sector can be subject to some pretty harsh movements and dividends from mREITs should not be the core source of income for an investor. However, they can be used to enhance the level of dividend income while investors wait for their other equity investments to increase dividends over the coming decades. If you want a really quick version to refer back to, I put together the following chart that really simplifies the role of each investment: Name Ticker Role in Portfolio SPDR S&P 500 Trust ETF SPY Core of Portfolio Consumer Discretionary Select Sector SPDR ETF XLY Enhance Expected Returned First Trust Consumer Staples AlphaDEX ETF FXG Reduce Beta of Portfolio Vanguard FTSE Emerging Markets ETF VWO Exposure to Foreign Markets First Trust Utilities AlphaDEX ETF FXU Enhance Dividends, Lower Portfolio Risk SPDR Barclays Capital Short Term High Yield Bond ETF SJNK Low Volatility with over 5% Yield PowerShares 1-30 Laddered Treasury Portfolio ETF PLW Negative Beta Reduces Portfolio Risk iShares Mortgage Real Estate Capped ETF REM Enhance Current Income Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. Despite TLT being fairly volatile and tying SPY for the second highest volatility in the portfolio, it actually produces a negative risk contribution because it has a negative correlation with most of the portfolio. It is important to recognize that the “risk” on an investment needs to be considered in the context of the entire portfolio. To make it easier to analyze how risky each holding would be in the context of the portfolio, I have most of these holdings weighted at a simple 10%. Because of TLT’s heavy negative correlation, it receives a weighting of 20% and as the core of the portfolio SPY was weighted as 50%. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio. Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. (click to enlarge) Conclusion REM offers investors exposure to a sector that has a fairly low correlation (less than .50) with the S&P 500. That low correlation combined with a strong dividend yield makes it an appealing option for many investors that do not understand mREIT accounting. When it comes to analyzing mREITs, the worst mistake I often see is investors buying on trailing dividend yield with only a cursory examination into whether the mREIT can sustain the dividend. It is a recipe for failure as share prices can drop sharply after an unsustainable dividend is cut. While the dividend yield is extremely strong, low prices are not necessarily indicative of “sales” because the damage to an mREIT portfolio from period of high volatility can be very material and the damage is generally permanent. When their assets are held at substantially more than par value due to favorable interest rates and the borrowers are paying off the loans at par value, the loss created is a real problem and does not simply correct itself in future periods. Limit the exposure, but using REM as a small part of a portfolio can work just fine. Compared to the presented portfolio, if an investor needed more yield I would contemplate dropping off FXG first and replacing it with more SJNK and then replacing some SPY with an ETF that emphasizes higher dividend yields and lower volatility. Scalper1 News
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