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Feeling Gravity's Pull

Amid significant underperformance in 2015 and likely more interest-rate hikes, can risky mortgage REITs turn things around? Here's a look at the largest mortgage REIT exchange-traded fund.

REM's 18% share-price decline in 2013--compared with that year's strong bull market for domestic stocks--demonstrates mortgage REITs' high risk profile. While attractive, their double-digit yields signal that this subsector is appropriate only for very risk-tolerant investors.

REM meaningfully underperformed the broader U.S. equity market in 2015. After the Federal Reserve lifted interest rates in December 2015, REM actually rallied slightly. Interest rates and sentiment regarding rate movements historically have had a major impact on mortgage REITs (investor uncertainty about interest rates prompted mortgage REITs' 2013 sell-off). At the same time, rising rates are not necessarily all bad for mortgage REITs. Higher short-term rates certainly increase funding costs, but the effect could be mitigated somewhat if long-term rates rise even faster, resulting in a steeper yield curve and a greater spread. (While many mortgage REITs hold fixed-rate residential mortgages and mortgage-backed securities, some hold variable-rate commercial property loans. As such, REM is exposed both to fixed-rate and floating-rate securities.)

Mortgage REITs' exposure to housing values varies. Agency REITs, such as Annaly Capital Management NLY, are not exposed to credit risk but have some exposure to housing prices because higher prices mean increased prepayment spreads. Housing prices have a far greater impact on nonagency REITs like PennyMac Mortgage Investment Trust PMT, as higher prices mean fewer delinquencies, lower borrowing costs, easier securitization, and fewer write-downs. For nonagency REITs, higher real estate prices typically mean higher earnings and payouts.

During the past five years, mortgage REITs have been slightly more volatile than the S&P 500. However, mortgage REITs were considerably less volatile than U.S. stocks in the immediate aftermath of the financial crisis--the result of their far more gradual recovery than the broader market.

Fundamental View Many mortgage REITs, such as Annaly Capital Management (15.5% of assets) and American Capital Agency AGNC (10.5%), invest in government or government-agency-backed MBS and use leverage to capitalize on the spread between short- and long-term interest rates. Such MBS have generally high credit quality, so these mortgage REITs face little to no credit risk but are very susceptible to rising interest-rate risk and a flattening yield curve. Other mortgage REITs, such as Colony Capital CLNY and Apollo Commercial Real Estate Finance ARI, invest in and, in some cases, originate mortgage loans, some of which are securitized. Still others, such as PennyMac Mortgage Investment Trust, invest in distressed mortgage loans.

More interest-rate increases are expected in 2016. Even small short-term rate upticks can have an impact on mortgage REITs' profitability. Certainly, rising rates pressure mortgage REITs' dividends, all other things being equal, although additional leverage can offset that somewhat. In past rising-rate environments, mortgage REITs cut their distributions and underperformed. Annaly and American Capital Agency cut their payouts in almost every quarter in 2013 after continued sell-offs. (Annaly's quarterly distributions were constant in 2015, while American Capital Agency cut its distribution by 9%.) REM's distributions (which are more volatile than equity REIT payouts or broad market dividends) make up as much as 80% of its total return, so cuts in payouts greatly reduce returns.

Mortgage REITs' future is uncertain. The Fed no longer is a regular buyer of MBS, and commercial banks largely have fulfilled their government-imposed requirements to add high-quality assets to their balance sheets, reducing MBS demand and causing higher rates for MBS borrowers. Several factors could boost MBS supply: If mortgage credit loosens, if the housing market improves meaningfully, if nonagency-to-agency refinancing goes up, or if banks revert to securitizing more loans instead of placing them on their balance sheets. While a greater MBS supply could have an impact on spreads, the MBS marketplace is far more stable now than it was in the past.

The majority of mortgage REIT financing is as short-term as 30 days, so if the capital markets freeze, these firms could be forced to accept unfavorable terms. And mortgage REITs likely would not be able to issue new shares, leaving as their only options either selling assets or taking unfavorable repurchase agreement rates. Lenders also can make margin calls following a market decline. Rising short-term rates mean higher funding costs for mortgage REITs. To lower their risk, many of these firms use interest-rate swaps. While interest-rate swaps have lowered the volatility of the book value of their equity, they do not help significantly in a "freeze-up" of short-term repurchase agreements. And interest-rate swaps have helped minimize the volatility of American Capital Agency's book value and earnings capability. Such swaps also have reduced their ability to pay higher dividends as the swaps pressure net interest margins lower. Also, American Capital Agency has cut its leverage some since the end of 2014, which reduces equity value risk but also pressures earnings and dividends.

Portfolio Construction REM tracks the market-cap-weighted FTSE NAREIT All Mortgage Capped Index. The index is weighted by market cap and screens constituents for size and liquidity. Most of REM's holdings are mid-cap and small cap. REM has large allocations to two mortgage REITs, Annaly Capital Management (15.5% of assets) and American Capital Agency (10.5%). These companies invest exclusively in agency-backed mortgages. REM tracked the uncapped version of its index before 2009, which led to significant tracking error: Annaly and American Capital each made up more than 25% of the uncapped index, but IRS rules stipulate that exchange-traded funds are not allowed to have more than 25% of their portfolio in a single security. After switching to the capped index in 2009, REM has tracked its index closely.

Fees REM charges 0.48% a year, which is expensive compared with equity REIT ETFs but average for funds that include mortgage REITs. REM's estimated holding cost, which measures the difference in performance between an ETF and its benchmark during the past year, is 0.30%.

When possible, REITs should generally be held in a tax-deferred account. Most of their dividends are taxed as ordinary income and don't benefit from the low 15% qualified dividend rate. The unfavorable tax treatment arises from the REIT legal structure, which, in exchange for no taxation at the company level, obliges the firms to pass on the vast majority of their earnings to shareholders.

Alternatives REM has few alternatives. The only other mortgage REIT-themed exchange-traded product is Market Vectors Mortgage REIT Income ETF MORT, which costs 0.41% a year. Like REM, MORT tracks a market-cap-weighted index. It also is a more concentrated ETF, holding 25 mortgage REIT firms compared with REM's 37. However, MORT has far fewer assets than REM and is thinly traded.

The only other ETF with a meaningful allocation to mortgage REITs is a financial-oriented ETF, PowerShares KBW High Dividend Yield Financial KBWD, which devotes about 28% of its assets to mortgage REITs.

IQ US Real Estate Small Cap ETF ROOF, which mostly holds equity REITs, devotes about 18% of its portfolio to small-cap mortgage REITs.

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