Market Overview

Under The Hood: A Closer Look at Yield ETFs

Under The Hood: A Closer Look at Yield ETFs

Many investors know that turning to ETFs for solid dividends and strong yields is a legitimate alternative to individual stocks and bonds. Simply put, there is no dearth of places for income investors to turn in the exchange-traded products universe.

Perhaps the biggest downside to the rapid proliferation of income-oriented ETFs is that it is becoming harder for some decent funds to standout. Such is life for the iShares FTSE NAREIT Mortgage Plus Capped Index Fund (NYSE: REM).

To be fair, the iShares FTSE NAREIT Mortgage Plus Capped Index Fund is by no means small or thinly traded. REM, which celebrated its fifth birthday in May, has $735.3 million in assets under management and average daily volume north of 752,000 shares. In other words, no tears should be shed for REM because it is clearly a successful ETF by any of the superficial metrics that ETF experts and investors are often seduced by.

Still, an in environment where dividends and dividend yields are everyday Wall Street buzzwords, REM is arguably not getting the praise it deserves. The fund is up 18.6 percent year-to-date and still sports a whopping trailing 12-month yield of almost 11.5 percent, according to iShares data.

Given its emphasis on mortgage REITs, REM's top holdings will not come as a surprise to investors that are familiar with this space. Annaly Capital Management (NYSE: NLY) and American Capital Agency (NASDAQ: AGNC) combine for more than 38 percent of REM's weight. Other top-10 holdings include CYS Investments (NYSE: CYS), Armour Residential (NYSE: ARR) and Invesco Mortgage Capital (NYSE: IVR). Overall, REM is home to 29 stocks.

REM, which features an expense ratio of 0.48 percent, is also a member of a unique ETF club: The double-digit yield club. According to Finviz data, just six exchange-traded products yield 10 percent or more.

REM's presence in the double-digit yield club is noteworthy if for no other reason than that it is arguably the highest quality product of the six. The iShares MSCI Spain Index Fund (NYSE: EWP) sports a yield of 12.1 percent because of Europe's sovereign debt crisis, implying a yield trap scenario. The Guggenheim Solar ETF (NYSE: TAN) tracks a downtrodden sector with deep fundamental flaws and that implies significant risk with a yield of 11.5 percent.

The other members of the double-digit yield club are either opaque in nature, marked by high fees or both. REM is the exception on all accounts. There is no such thing as risk-free equity investment and that is the case with REM. Should the yield curve flatten, mortgage REIT yields would be depressed and any uptick in interest rates would expose these REITs to prepayment risk. A spate of prepayments has the potential to drive amortization costs higher for the likes of Annaly and American Capital, in turn providing a drag on earnings.

In REM's favor is the fact the ETF has outperformed Annaly this year and a beta of just 0.55. Should the Federal Reserve make good on its promise to keep interest rates low through at least late 2014, the bear case for REM may not come into play for another 18-20 months. In the meantime, investors can enjoy a double-digit yield.

For more on mortgage REIT ETFs, click here.


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