mREITs: The Perfect Hedge?

May.22.12 | About: Annaly Capital (NLY)

Every time markets tumble, many investors are reminded about the benefits of hedging. (I must admit I am such an investor; my portfolio has suffered quite a bit along with the broader market over the past few weeks.)

There are many ways to hedge; some investors prefer to do so by utilizing a long-short strategy, in which an investor will hold stocks that he believes to be high-quality while shorting ones that he believes to be weaker. Other investors may choose to use derivatives to moderate exposure to a specific strategy or class of security. Still others may invest in alternative asset classes, such as precious metals like gold (NYSEARCA:GLD) or resources like oil. However, during this correction, I realized that my exposure to the market was being hedged very effectively by a relatively-traditional equity security - my shares of Annaly Capital (NYSE:NLY).

Annaly is a mortgage real estate investment trust (mREIT), but due to the fact that it only invests in government-affiliated securities, it's really just a vehicle that uses leverage to generate a large return for shareholders. (Annaly borrows money at lower rates and buys securities that pay higher rates, profiting off of the spread and the leverage.) The REIT structure mandates that Annaly distributes at least 90% of its income as dividends, which currently translates into a 13% yield for shareholders.

Because of this structure, business model, and the type of investor that buys NLY shares, Annaly's day-to-day trading is generally less volatile than the overall market. Annaly's beta of .23 (according to Yahoo! Finance) means that, on average, if the S&P 500 falls 1%, Annaly will fall just .23%. But how did this actually pan out during the recent correction?

The S&P 500 (NYSEARCA:SPY) fell from 1420 in early April, and as high as 1410 in early May, to below 1300, losing most of that value during the thirteen trading sessions ending May 18, which featured eleven down days, as seen below. (All charts are courtesy of StockCharts.com.)

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This drop can also be seen in the chart below; the S&P 500 is the light blue line at the bottom of the graph. The other lines on the chart are MREIT-related securities - Annaly, Chimera (NYSE:CIM), American Capital (NASDAQ:AGNC), and a MREIT ETF (NYSEARCA:MORT). In terms of absolute performance, AGNC topped the group with a gain of over 5%, with NLY a few percent lower but still in positive territory; both CIM and MORT suffered losses during this period.

mreits chart hedge spy s&p 500Click to enlarge

However, as is even clearer on the graph below, the mREIT asset class clearly outperformed the S&P 500 during this correction. American Capital beat the index by almost 15%, and NLY was more than 10% better that the S&P 500, and even CIM and MORT, which suffered absolute declines, beat the index by about 5%. (If dividends are factored in, outperformance is even greater; in this approximately two-month time frame, a mREIT-holder earns an imputed dividend of about 2%, while the dividend on the S&P 500 during the same period is under 1%.)

As an aside, CIM's relative underperformance may be related to its relatively high beta of .84 - it trades roughly in-line with the overall market. Compared to Annaly (.23) and AGNC (.24), it appears to offer less of a hedge and more market-like performance (which can be a good thing if the overall market is moving higher).

Click to enlarge

I originally bought NLY for the 13% dividend, but I now know that it deserves a place in my portfolio for another great reason - it helps moderate performance, which is very desirable when the overall market weakens. Most MREIT investors understand that income production, not capital appreciation, is the main way to profit from MREITs anyway, but capital preservation during a downtrend is an excellent added bonus. Simply put, I believe that most investors should consider allocating at least a small percentage of a portfolio to mREITs, and if hedging is the desired outcome, choose one with a low beta.

In conclusion, if the mREIT industry ever felt like advertising, I have a slogan to suggest: "mREITs: What can't they do?"

Disclosure: I am long NLY.