Can’t Find a Favorite Mortgage REIT? Own the Industry with this ETF

by JT on October 7, 2012

A little known REIT ETF has outperformed the market, and provided a whopping 11% yield along the way. iShares’ FTSE NAREIT Mortgage REITs Index (REM) excels in delivering the highest yields with broad exposure to the market for real estate investment trusts.

The fund makes for an interesting exchange-traded fund in that it has one of the worst tracking errors in the business. The fund seeks to track the FTSE NAREIT All Mortgage Capped Index, but because the underlying index tends to be more concentrated than laws allow for exchange-traded funds, it should be viewed as an actively managed ETF. ETFs cannot hold more than 25% of their assets in a single security.

In theory, the iShares FTSE NAREIT Mortgage REITs Index (REM) should be last on the list of REIT selections due to its tracking error. In practicality, its tracking error is the result of aggressive diversification, which may provide value to investors who want broad exposure to the mortgage REIT industry. Diversification has a limited impact on returns – the fund pays dividends of more than 11% per year.

Fund Holdings

Investors familiar with the high-yield mortgage REIT market will recognize many of the funds top 10 holdings:

Annaly Capital Management, Inc. (NLY) – 21.84%
American Capital Agency Corp. (AGNC) – 16.87%
Two Harbors Investment Corp (TWO) – 4.69%
MFA Financial, Inc. (MFA) – 4.61%
Chimera Investment Corporation (CIM) – 4.49%
Hatteras Financial Corporation (HTS) – 4.32%
Starwood Property Trust, Inc. (STWD) – 4.31%
CYS Investments Inc (CYS) – 4.16%
Invesco Mortgage Capital Inc (IVR) – 4.11%
ARMOUR Residential REIT Inc (ARR) – 4.03%

The fund holds its biggest positions in the two dominant mortgage REITs, Annaly Capital (NLY) and American Capital Agency Corp (AGNC). Behind these two are 28 other ETFs, which make up less than 4% of the portfolio each. The iShares FTSE NAREIT Mortgage REITs Index (REM) holds 30 mortgage REITs and specialty finance companies.

Exposure to up and Coming Funds

What makes the iShares’ FTSE NAREIT Mortgage REITs Index (REM) ETF different is its broad diversification extending all the way down to Arbor Realty Trust, Inc.(NYSE:ABR), a tiny $158 million trust involved in specialty mortgage finance.

As investors know, the value of a REIT is defined by its management. Management has the ability to move funds to new mortgage backed securities, choose portfolio leverage, and hedge interest rate risk with derivatives. Buying a basket of ETFs somewhat removes the value of the manager, exposing investors to a broad base of mortgage-backed securities levered with short-term financing arranged by the trusts’ managers.

iShares charges a small .48% annual expense fee, making it an inexpensive way to grab exposure to every corner of the mortgage REIT market. With mortgage REITs boasting incredible dividends and year-to-date returns, this ETF has delivered with stellar performance:

Capital gains account for 19% of this years’ 30% return. Dividends account for the remainder. Scoring a beta of .66, the fund is weakly correlated with the broad market, likely due to yield-chasing, which has sent mortgage REITs flying higher as interest rates plummeted.

Bottomline on iShares’ FTSE NAREIT Mortgage REITs Index

What you see is what you get. iShares’ fund makes it possible to buy a collection of REITs yielding 11% per year at a price of only .48% per year. (See our High Yield ETF section for more similarly themed alternatives). Investors who want broad exposure to the REIT market and wish to limit their trading costs and fund fees would be wise to turn to iShares’ fund as a diversified entry into the mortgage REIT market.  Conversely, you could actually target the highest yielding REITs individually via this list of REITs numbering close to 100.

Disclosure: The author has no positions in the tickers above, but is currently long American Capital Ltd. (ACAS), the parent company of American Capital Agency Corp. (AGNC).

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