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Investing one's wealth should always be done in an organized, methodical, disciplined manner. Too often we see investors buying and selling securities based on the merits of the individual securities without really considering how it fits into their overall investment portfolio. To us, this could be a recipe for disaster. The more practical approach is to develop an asset allocation strategy determined by your investment objectives, risk tolerances, income needs, time horizon, and any other unique circumstances that should dictate the way you should position your investment portfolio.

Strategic Asset Allocation

The asset allocation strategy is a result of the investment objectives defined by your own unique circumstances. It results in specific target percentages to invest in each asset class, with each asset class having different characteristics that may contribute to the overall investment goals you have defined. Only when the asset allocation strategy is determined should you be evaluating individual securities within each asset class. Not doing so is akin to building a house without first establishing its foundation.

Going back to our asset allocation strategy for example, an investor looking to preserve wealth but who may be willing to take some risk to grow capital, may determine that the proper asset allocation strategy may consist of 60% invested in equities and 40% invested in fixed income.

Once established, an investor can then choose which specific equities to invest in and which specific bonds to purchase, so long as the overall percentages remain within the 60/40 split established at the asset allocation level.

You can also define a more detailed breakdown of each asset class, for example, by further defining the Equity portion into US Equities, Non-US Equities, Emerging Market Equities. Further defining the percentage allocation to each sub-category is still considered part of the strategic asset allocation, it's just a matter of preference how detailed you might want to be.

Tactical Asset Allocation

The more active approach of portfolio management is to make tactical allocation changes to represent a particular view of the macroeconomic environment and/or a specific asset class. This approach may take one of two forms. For example, in the current environment, we are bullish on Emerging Market equities and may want to overweight our portfolio to this asset class. To make a tactical adjustment, let's assume that the strategic asset allocation to Equities was as follows: 30% US Equities, 20% to Non-U.S. Equities, and 10% to Emerging Market Equities, for a total of 60% in equities. With a more favorable view on Emerging Market Equities, we may tactically allocate a greater percentage to Emerging Markets, to say 15%, by reducing either U.S. Equities or Non-U.S. Equities, or by simply increasing the total allocation to equities to 65%. How we rearrange the other asset classes will depend on our views for each of them as well.

The second way we can make a tactical asset allocation adjustment is to temporarily allocate to an asset class we don't normally hold in our strategic portfolio. While the strategic portfolio is called our core investments, a short-term allocation to another asset class would be considered a satellite approach. The general investment approach just described is often called the core/satellite approach and according to Goldman Sachs:

We believe creating an efficient portfolio means maximizing your return potential for a given level of risk. We feel that one way to accomplish this is through a Core and Satellite approach.

In a Core and Satellite approach, investments are divided into two categories:

Examples of core investments include US Large Cap stocks, US Small Cap stocks and US fixed income.

Core strategies provide exposure to asset classes that are broadly representative of the market.

Satellite strategies have the potential to deliver higher returns derived from skilled active management. Examples include REITS, Commodities, High Yield Bonds and Emerging Markets.

The satellite investments are designed to complement the core portfolio, while taking advantage of the opportunities in the market environment over shorter periods of time.

An example of this type of asset class, as stated by Goldman, are REITs, and more specifically in our example, mortgage REITs. For a more general approach to using REITs in your portfolio, see our September 24 article on Seeking Alpha (Read Article). While we would agree that REITs may well be part of an investors strategic asset allocation, we think that mortgage REITs are opportunistic investments that provide better risk-adjusted returns in certain environments than they do in others.

In this environment of historically low interest rates, for example, mortgage REITs are great yield/income enhancers that complement longer maturity and high yield bonds. We are not suggesting replacing these asset classes, but rather, shifting some of the allocation you would normally have in them to incorporate some mortgage REITs. Not only does this help further diversify your portfolio, but helps make up for the reduced yield and income that this environment of low rates has produced.

Choosing Mortgage REITs

So which mortgage REITs should you invest in? First, let us warn you that mortgage REITs, like other fixed income investments, can be hurt by unexpected or rapid rises in interest rates. Many mortgage REITs actually hedge against a rise in interest rates and while management for each company feels that these risks are well managed, as an investor, we always prefer to be cautious as we won't really know how well hedged a company is until interest rates actually begin to rise.

Our recommendation therefore, is to invest in a diversified portfolio of REITs that have slightly different approaches to investing in these securities and therefore, are exposed to unique risks and at quite possibly to varying degrees. If you prefer to buy a diversified ETF that holds a number of different REITs, then perhaps you should consider the iShares FTSE NAREIT Mortgage Plus Capped Index Fund (REM). It's largest holdings are Annaly Capital (NLY) and American Capital Agency Corp (AGNC) at 21% and 16%, respectively. However, in our opinion, these two companies have very similar strategies and are exposed to the same risks.

So we would prefer to construct a diversified portfolio of mREITs with varying strategies that while not as diversified in terms of number of holdings, may be considered more diversified in terms of the risk profile of the portfolio.

The Components of the Portfolio

If you have been reading our series on Comparing Mortgage REITs, you probably already have a good idea of which mREITs we would include in our portfolio. Our favorite picks from each of the four Part series are highlighted below.

American Capital Agency Corp

American Capital Agency was our favorite pick in Part 1 of Comparing Mortgage REITs (Read Article). It invests primarily in Agency Mortgage Backed Securities, which are theoretically free of credit risk because of the implied backing of the US Government. Agency MBSs are those backed by government sponsored agencies Fannie Mae, Freddie Mac, and Ginnie Mae. We particularly like the profile of AGNC's portfolio, which consists of low coupon fixed rate mortgages and high LTV mortgages that are less susceptible to prepayments than adjustable rate, higher coupon, or lower LTV mortgages. AGNC also has a very competitive cost structure with operating expenses towards the bottom relative to industry peers.

Capstead Mortgage Corporation (CMO)

Even though our favorite mREIT in Part 2 of Comparing Mortgage REITs was American Capital Mortgage Investment Corp (MTGE), we would prefer to add Capstead to our portfolio (Read Part 2). For one thing, MTGE is a smaller relative of AGNC, with the same management and same investment philosophy, while Capstead seems to be more comparable to investing in a floating rate note. Even though we don't expect interest rates to rise anytime soon, Capstead invests primarily in adjustable rate mortgage backed securities. This means that as interest rates rise, the coupons they will be receiving will also increase, albeit with a lag. The biggest risk for Capstead however, is the higher probability of prepayments. As an increasing number of borrowers refinance to lock in a fixed rate, the constant prepayment rate (CPR) for Capstead may actually increase even before rates rise, causing a decline in the yields on its portfolio. And while this may be the biggest risk faced by Capstead, it is the lowest risk faced by AGNC. We must therefore admit, that this is the primary reason we would combine AGNC with Capstead.

Invesco Mortgage Capital (IVR)

Invesco was our favorite pick in Part 3 of Comparing Mortgage REITs (Read article) and we also wrote a follow up article after it reported 3Q results (Read article). Invesco employs a hybrid strategy consisting of investments in both Agency and Non-Agency MBSs. As we stated earlier, the Agency MBSs have an implied government guarantee while the Non-Agency MBSs are exposed to credit risk. Not surprisingly, the Non-Agency MBSs have higher yields than the Agency MBSs. In addition, Invesco invests Commercial Mortgage Backed Securities (CMBS) that also have higher yields than Agency MBSs. While they carry more risk, we note in our previous article that it is slowly improving the quality of it's CMBS portfolio while having very little negative affect on the yield it is receiving.

Resource Capital (RSO)

In Part 4 of our series on Comparing Mortgage REITs (Read here), we introduced mREITs with more specific niche strategies that had not been covered before. The mREIT that stood out most to us was Resource Capital. RSO invests primarily in bank loans, which have very short maturities, and are a favored asset class in our view. First of all, we think Resource Capital is minimally impacted by prepayment rates. The maturities of the bank loans it holds are short enough that a high CPR would not have much of an impact to its strategy. It is however, exposed to credit risk, which we think is properly managed through asset selection and short-term maturities. The asset yield on its portfolio is over 6% and its leverage is a modest 4.3 times.

Constructing the Portfolio

Even though we have only highlighted four mREITs in our article, we would not criticize anyone for constructing a portfolio of five, six, or more mREITs to further diversify your portfolio. In fact, a combination of mREITs with an allocation to REM may be another approach that can be considered.

If you prefer to do it our way, then we suggest the following:

American Capital Agency Corp is probably the safest bet of the group so we would allocate the highest percentage of our mREIT exposure to it. Secondly, we would want to reduce the overall exposure to interest rate changes so we would look to invest a considerable amount to Resource Capital. Thirdly, we like the hybrid strategy used by Invesco Mortgage so we would allocate the next highest amount to it. And finally, because of the risks of rising prepayments, we would allocate the least amount to Capstead, even though we like the adjustable rate components of its portfolio.

The portfolio of mREITs within an otherwise well diversified portfolio of other assets may look something like the following but can be adjusted for your specific circumstances or preferences.

American Capital 40%

Resource Capital 30%

Invesco Mortgage 20%

Capstead Mortgage 10%

Our recommendation is that the mREIT portion of your portfolio be no more than 20% if you are an aggressive investor with a high risk tolerance. While it should be no more than 5% if you are extremely conservative with a high priority on wealth preservation in lieu of income and growth.

The Results

Note: the results shown are a weighted average of the four mREITs names and may not reflect the true performance of a combined portfolio

The results shown above look quite promising. The projected yield is a hearty 13% and we shift the portfolio to a more balanced 58% fixed and 42% adjustable. We recognize that this may expose you to higher prepayments in the short term, but will be better insulated from interest rate increased in the longer term.

As we illustrate in the correlation table below, all of the mREIT correlations are below .55. Even though we would prefer to see these correlations even lower, we at least find comfort in that combining these mREITs will reduce the risk of your mREIT exposure.

source: Bloomberg 2008-2012

Conclusion

Investing in mortgage REITs can enhance yield and income in an environment where yields on other asset classes have dropped to historic levels. However, investing in mREITs is not without its risks. Some mortgage REITs are exposed to interest rate risk while others choose to take on credit risk. Whether these risks actually result in losses and/or decreases in income for an investor depends on the specific strategy employed by each mREIT and the capability of management to implement that strategy. As the economic environment evolves, the better managed mREITs will certainly provide a higher level of safety than those managed by less experienced professionals. One of the best managed mREITs in fact, is not included in this article. That mREIT is Annaly Capital, which undoubtedly has the best management in the industry. But when we performed our analysis, we preferred to include American Capital Agency Corp.....this time. If we did this exercise in 6-12 months, the results may differ.

So don't be married to these names. As the economic environment plays out and we begin to have more visibility on interest rates, default rates, etc., we may revisit this portfolio.

mREIT Summary

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Source: Constructing A Portfolio Of Mortgage REITs Using A Satellite Approach