New Mortgage ETF Buys Stocks, Not Bonds

By Murray Coleman

Anticipating a return in U.S. mortgage markets, State Street Global Advisors launched Thursday an exchange-traded fund focusing on companies involved in that corner of the market.

The SPDR KBW Mortgage Finance ETF (KME) takes a different approach than other financial-focused funds on the market. It holds banks dominated with mortgage loans on their books as well as related service providers. The biggest of those names in the fund's index heading into the launch were Hudson City Bancorp (HCBK), New York Community Bancorp (NYB) and NewAlliance Bancshares (NAL).

But the new ETF also includes a healthy dose of title insurers and claims managers such as Fidelity National and Lender Processing.

If that isn't diversified enough, home builders also are well-represented in the index with stocks from D.R. Horton (DHI), Centex (CTX) and Lennar (LEN), to name just a few.

Name	Ticker	1-Mnth (%)*	YTD (%)*	12-Mnth (%)*	Weight (%)*
Hudson City Banc	HCBK	8.6	-18.4	-31.4	7.66
NY Community Banc	NYB	4.4	1.60	-32.4	7.52
D.R. Horton	DHI	110.70	83.60	-21.00	7.00
Fidelity National	FNF	-3.30	2.90	18.70	6.72
Lender Processing	LPS	-1.00	2.60	--------	4.73
NewAlliance Banc	NAL	14.30	2.70	2.50	4.57
Centex	CTX	24.30	6.80	-48.60	4.50
PHH Corp.	PHH	21.80	34.40	-12.40	4.47
MDC Holdings	MDC	4.60	15.40	-20.80	4.46
Lennar	LEN	-1.90	16.80	-14.80	4.29
Vanguard SC Value	VBR	10.00	-1.25	-31.83	----
iShares Russ 2000	IWM	8.23	-0.21	-30.57	----
iShrs MC Russ Val	IWS	7.09	-1.27	-37.17	-----
SPDRs MidCap	MDY	9.24	4.90	-32.42	------

Sources: KBW, SSgA, NYSE, Morningstar *Through April 29, 2009

The ETF, which comes with an expense ratio of 0.35%, uses a benchmark created by investment banker and asset manager Keefe, Bruyette & Woods. The new ETF joins four other SPDRs using KBW indexes to slice financials into different subsectors.

There are several ETFs that invest in mortgage-backed securities, including the iShares Barclays MBS Bond Fund (MBB). The SPDR Barclays Capital Mortgage Backed Bond ETF (MBG) also competes in that area of the fixed-income market. PowerShares has also filed to come out with a pair of actively managed MBS-focused ETFs. Those would buy securities backed by prime and Alt-A mortgages.

SPDRs ETFs	Ticker	1-Month*	YTD*	12-Month*
Banks Sector	KBE	14.39%	-23.70%	-58.03%
Regional Banks	KRE	9.95%	-25.40%	-35.93%
Insurance Sector	KIE	17.09%	-10.56%	-48.57%
Capital Markets	KCE	10.70%	10.96%	-46.67%

Source: KBW *Through April 29, 2009

But until now, none has ventured into investing solely in stocks of mortgage lenders and related services firms. And there's good reason. Longer-term returns haven't been so hot for the group compared to other subsectors in the broader financial sector (see table below).

Still, considering the first table above, it's obvious why investors might find KME appealing at this point. The returns of its biggest index names heading into Thursday show how mortgage markets have been rallying lately. (The top 10 constituents represent nearly 56% of the benchmark's weightings.)

Most of the ETF's 24 names now fall within the small- and mid-cap range. A few have drifted lately to show more growth-oriented attributes. But either way you look at it—as a fund slanted toward value or one favoring a more blended approach—the combination of homebuilders, banks and mortgage loan servicers takes a widely divergent view of mortgage markets.

It's interesting to note that KME's underlying index was up 4.40% for the year through Wednesday. That's better than more diversified small- and mid-cap ETFs of various styles. And during the past month, the KBW Mortgage Financial Index had jumped more than 15.5%—a huge showing of outperformance over broader smaller-cap benchmarks.

KBW Index	1-Month*	YTD*	12-Months*	3-Years*	5-Years*
Banks Sector	19.27%	-23.51%	-58.09%	-30.59%	-15.86%
Insurance	22.32%	-10.18%	-48.43%	-21.15%	-9.03%
Regional Banks	11.46%	-25.68%	-35.93%	-21.12%	-9.30%
Capital Markets	12.42%	11.30%	-46.51%	-20.61%	-4.84%
Mortgage Finance	15.59%	4.40%	-56.59%	-40.44%	-24.84%
S&P 500 Index	9.67%	-2.41%	-35.50%	-10.72%	-2.80%

Source: KBW *Through April 29, 2009

In the past 12 months, however, the KBW Mortgage Financial Index had lost more than 56.5%. That's probably a pretty good snapshot of mortgage markets these days—outperformers now, but big laggards in the past several years.

If mortgage stocks are really surging, KME could prove to be an interesting way to capture much of the industry's upside. And an ETF based on a modified market-capitalization weighted index with a concentrated portfolio poses another attraction for any extended run—it will naturally hold the strongest lenders.

The list of banks and thrifts included in KME's portfolio, for example, are filled by financial institutions with relatively conservative lending practices that have served them well in the ongoing credit crisis.

But on the flip side, KME figures to be more volatile on the downside if another bubble forms in mortgage markets. The longer-term performances of other KBW indexes slicing and dicing financial services raises questions about using the new ETF as a buy-and-hold vehicle. KME is likely to appeal to traders and institutional investors looking to overweight financials. But as the third table above shows, they'd be wise to watch it like a hawk.

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