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A common investing theme over the last year has been to allocate into income producing ETFs, including equity, MLP and REIT ETFs. The broad move into dividend paying ETFs by retail investors seems highly apparent in the two main ETFs that offer broad industry exposure to U.S. residential mortgage REITs.

The iShares FTSE NAREIT Mortgage Plus Capped Index Fund (NYSEARCA:REM) has now appreciated by about 19% so far in 2012. REM's assets under management have grown by around $200 fueled by a surge in net inflows this year, or well over fifty percent annualized growth from last year. Additionally, Van Eck's Market Vectors Mortgage REIT Income ETF (NYSEARCA:MORT) has appreciated by about 18% since the start of 2012, and has about $47 million in assets, with inflows up about 100% this year. Van Eck founded MORT in August of 2011, and so it has just turned one, while REM is about five years old.

Both of these ETFs have investment policies that indicate highly passive and index-linked investment styles. MORT has a policy to invest at least 80% of its total assets in securities that make up the fund's benchmark index, the Market Vectors Global Mortgage REITs Index, which is made of publicly traded U.S. mortgage REITs that derive at least 50% of their revenue from mortgage-related activity. Similarly, REM has a policy to invest at least 90% of its assets in securities of its underlying index, the FTSE NAREIT All Mortgage Capped Index. REM currently has an expense ratio of about 0.48 percent, while MORT has a slightly lower 0.40 percent expense ratio. MORT is a newer ETF, and as MORT's volumes increase, REM will likely attempt to reduce its expense ratio.

Mortgage REITs, or mREITs, buy mortgage paper as an investment, or in order to re-sell the paper to a competing mREIT or another entity that invests in real estate loans. Most mREITs are known for their high yields. Agency mREITs buy mortgage paper that is backed by federal agencies. Non-agency mREITs hold mortgage paper without such a government agency backing, though these companies also can and do buy large positions in agency paper.

Both agency and non-agency RMBSs have appreciated in 2012. These two ETFs are mostly invested in agency mREITs, but do have significant non-agency exposure. Both companies not only have similar holdings, but they also have similar position sizes within each of these holdings. Both REM and MORT have their largest position in Annaly Capital Management (NYSE:NLY), which is the largest agency mREIT, and their second largest position in American Capital Agency (NASDAQ:AGNC), which is the second largest agency mREIT. Both also have comparable smaller positions in numerous hybrid/non-agency mREITs, and both have a similar sized position in Starwood Property Trust (NYSE:STWD), a commercial mREIT.

Both mREIT ETFs increased their dividends last quarter, which is due to that non-agency exposure and prepayments, as most agency mREITs did not increase their payouts. Agency mREITs have largely had to reduce their payouts over the last several quarters due to reduced spreads, though most agency mREITs have appreciated to a far greater extent than their dividend reductions. REM last increased its quarterly payout from $0.4147 to $0.4407, a 6.2 percent increase, while MORT increased its quarterly dividend from $0.6270 to $0.7030, a 12.1 percent increase.

In a low-rate environment, with 7-10 year Treasuries yielding well below 2%, many investors have and may continue to buy into mREITs and mREIT ETFs, as well as many other high dividend paying ETFs that allocate into the mREIT industry. Both Treasury and mREIT valuations indicate that the markets anticipate a third round of economic stimulus by the U.S. Federal Reserve, and that mortgage REIT valuations will receive a valuation boost from that stimulus, even though dividends should suffer.

As mortgage-backed security yields have fallen over the past year, managers were forced to increase their leverage and/or buy riskier securities. Buying leveraged bonds at some of the lowest rates ever seen may be a dangerous long-term strategy, especially if interest rates climb. Nonetheless, the market currently appears sufficiently comforted by the Federal Reserve's promise and ability to keep borrowing rates low through 2014.

Most investors that recently allocated into mREITs on account of the Federal Reserve's continued action apparently intend on exiting before rates increase and fellow investors flee. Mortgage REIT ETF risks appear mounting, and their growing appeal to retail investors may indicate the industry has grown overexposed, especially as we approach the potential volatility of again soon reaching the U.S. debt ceiling. Investors should be wary of recent mREIT valuation highs and the potential concerns looming for their valuations in the coming quarters.

Source: Investors Should Be Wary Of Growing Retail Investor Allocations Into Mortgage REITs