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iShares FTSE NAREIT Mortgage Plus Capped Index Fund (REM) is one of the most interesting Exchange Traded Funds sponsored by the iShares company. This investment vehicle aims for tracking the general price and yield performance of the FTSE NAREIT All Mortgage Capped Index. In order to achieve this aim, the fund managers invest in mortgage-backed real estate investment trusts, also known as, mREITs.

Naturally the fund offers a relatively direct exposure to several stocks with the mREIT space. While ETFs issued by iShares Company tend to be popular with mostly positive reviews, Morningstar suggests only a single-star rating for this ETF. I think it is probably due to the fact that this fund is heavily concentrated in two of the largest companies in this field. While there are more than 25 equities in this ETF, Annaly Capital (NLY) is the largest holding, followed by American Capital Agency (AGNC). Together, these two mREITs constitute at about 40% of the fund's portfolio. The dominance of these equities makes it hard to claim a diversified portfolio.

The fund has also substantially underperformed its benchmark index in the recent years. Since its inception in 2007, the fund returned -52.86%, whereas the benchmark index returned -36.55%. It is hard to blame the the low annual management fee of 0.48% for this huge tracking error. Morningstar suggests an annual turnover rate of 63%. Since the transaction costs are implicitly reflected in the fund's performance report, I believe that might be another reason for the large gap between the ETF's performance and the benchmark index. There might be several other reasons as well. The management might be picking the winners, while shredding the losers from the portfolio. Reasons for this fund's underperformance are worth to investigate further, but that is beyond the subject of this article.

I am not a big fan of ETFs anyways. ETFs aim to offer a diversified portfolio for lower risk. I think any well-informed investors should be able to create a diversified portfolio from individual stocks. Since most REM investors like this fund due to its yield, I suggest investors to focus on the top 10 yielders in this ETF. Following is a list of the top 10 dividend stocks in the iShares FTSE NAREIT Mortgage Plus Capped Index Fund. I also listed their year-to-date performance, dividend yields, and debt-to-equity ratios for your convenience:


Company

P/B

Dividend Yield

Float Short

Total Debt/Equity

Performance (YTD)

Invesco Mortgage Capital Inc. (IVR)

1.03

18.13%

4.72%

6.4

24.94%

ARMOUR Residential REIT, Inc. (ARR)

1.04

17.52%

5.15%

8.52

1.93%

American Capital Agency Corp.

1.09

16.62%

1.50%

7.82

11.61%

American Capital Mortgage (MTGE)

1.05

16.51%

8.23%

8

20.44%

Two Harbors Investment Corp. (TWO)

1.1

16.06%

3.22%

5.24

12.04%

Chimera Investment Corporation (CIM)

0.84

16.06%

2.78%

1.85

13.22%

Resource Capital Corp. (RSO)

0.96

15.44%

4.74%

4.21

-4.25%

CYS Investments Inc (CYS)

1.01

15.15%

10.56%

7.3

4.27%

Annaly Capital Management, Inc.

0.97

13.97%

5.00%

5.41

2.14%

MFA Financial, Inc. (MFA)

1.01

13.52%

3.15%

3.48

9.23%

Average

1.01

15.90%

4.91%

5.82

9.56%

(Data from Finviz and individual company profiles)

As one can easily observe from the table above, the top 10 dividend stocks in the Mortgage Plus Capped Index Fund offer an average trailing yield of 15.90%. The lowest yielder is MFA Energy. However, even the lowest dividend payer in the above list offers a higher yield than REM which has a yield of 11.93%. Invesco Mortgage Capital is the highest yielder with a yield of 18.13%.

The debt-to-equity ratio is also another important indicator. When comparing mREITs with each other, this ratio serves an important purpose. It shows the relative exposure of each company to debt-based leverage. The lower this ratio, the safer is the dividend. Risk adverse investors should prefer companies with low debt-to-equity ratios. The mREITs in the above list support an average debt/equity ratio of 5.82. For comparison, the two largest holdings in the REM, Annaly Capital and American Capital Agency have debt/equity ratios of 5.41 and 7.82.

Why do mREITs have such huge debt/equity ratios? As SA contributor John Dalt suggests, mREITs use leverage in their balance sheets, to make the most out of the interest-rate spread. Consider Annaly Capital for example: Its current debt/equity ratio is 5.41, suggesting a leverage ratio near that level. This leverage ratio shows the way Annaly finances its current mortgage-backed loan portfolio. About 80% of its assets are financed through short-term debt. Thanks to this leverage, the company was able to provide an average return on equity of 13.42%, from an interest spread of 2% - 3% between long-term mortgage securities and short-term securities. Hybrid mREITs which invest in both agency-backed and non-agency backed mortgage securities tend to have lower leverage. Chimera has the same management with Annaly, but its leverage ratio is much lower due to its exposure to non-agency backed securities.

Another important ratio is the price to book ratio. mREITs rarely trade above their book value. Therefore, one should look for mREITs that are trading with a discount to the book valuation.

Summary

I am a big of dividend paying stocks and mREITs are among the top dividend payers in the market. The distributions provided by these companies are subject to favorable tax rules. mREITs are exempt from corporate taxes as long as they distribute at least 90% of their income in the form of dividend payouts. That creates a significant tax advantage over other companies. My safety criterion for mREIT valuation is a double-digit yield which is fully-supported by a single digit trailing P/E ratio. The stock should also be trading close to its book value. In fact a discount to book value is preferred, as mREITs rarely trade above their book value. Most mREITs listed in this article fit into my safety criteria. Besides, since its inception, Mortgage Plus Capped Index Fund has significantly underperformed its benchmark index. Therefore, investors looking for a better deal should instead invest in individual stocks within this ETF. The list above can serve as a good starting point for yield-oriented investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.