RomoloTavani

Thesis

The iShares Mortgage Real Estate Capped ETF (BATS: REM) suffered larger corrections along with the overall stock market. Namely, it suffered a total loss of 11.7% over the past year against the backdrop of a 4.7% loss for the S&P 500. index. Such a correction pushed its dividend yield to 7.2%, which is quite attractive for income-oriented investors. By comparison, the overall equity market only returns around 1.45% and Treasuries around 2%.

However, investors should be aware of the main potential risks before committing. As you can also see from the chart below, the higher return comes with a much higher volatility risk. Its total loss over the past year was almost 3 times that of the entire stock market. And as we will see next, it also comes with a few other key risks.

Return ETF REM

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REM: basic information

Just in case some readers are not yet familiar with REM, the following table shows its basic information. REM is an iShares fund with $842 billion in assets under management. In terms of expenses, REM charges a lower expense ratio of 0.48%. The objective of the fund is to provide targeted exposure to US mREIT stocks, as set out in the fund description:

  • The iShares Mortgage Real Estate ETF seeks to track the investment results of an index composed of US REITs that hold US residential and commercial mortgages.
  • It provides targeted access to a subset of national real estate stocks and real estate investment trusts (REITs), which invest directly in real estate and trade like stocks.

REM ETF Highlights

iShares Fund Description

Concern 1: Very heavy indexation and concentration risks

Due to its targeted exposure to mREITs and indexing by market cap, the fund is extremely heavy and carries considerable concentration risk. The 10 main holdings are listed below and they represent more than 67% of the total net assets, ie more than 2/3. The 3 main holdings represent more than 36% of total assets. And I recently wrote articles to detail the headwinds (such as yield curve inversion and recession risks) on two of them: AGNC Investment Corp (AGNC) and Annaly Capital Management Inc (NLY ).

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Concern 2: Low dividend yields relative to historical average

In my view, current performance does not adequately compensate for future risks. On the face of it, its 7.2% yield looks attractive relative to the broader equity market (1.45%) or Treasuries (~2%). But as you can see from the following chart, its current yield is at the lower end of its historical spectrum. To be more specific, REM’s dividend yield fluctuated in a wide range (another sign of significant volatility risks) between a low of 3.4% and a high of 25%, with an average of 10.09% over the past 10 years. As a result, its current dividend yield of 7.24% is currently below its historical average by a substantial margin of nearly 30%.

REM dividend yield

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Concern 3: Leverage and volatility risks

As mentioned above, REM has historically exhibited much greater price volatility than the broader stock market. And the chart below illustrates its longer-term volatility. The equity market (represented by the S&P 500) had a long-term standard deviation of around 16%, while REM’s standard deviation was around 23%. In terms of worst performance of the year, the overall market suffered a loss of 37% in the worst year, while REM suffered a loss of 42%. And in terms of the maximum decline, the overall market suffered a 48% (which is already nerve-wracking because a 48% decline takes a 92% rally to break even). And REM suffered an even bigger drop of 57%, which takes a 132% rally to break even.

One of the fundamental reasons for the high volatility is the use of leverage in the mREIT industry. And as I argued in my recent articles analyzing NLY and AGNC, I believe these stocks are still heavily leveraged. And therefore, I expect such volatilities to persist.

Growth of the REM portfolio

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Controlling volatility through diversification

As a workaround, investors could consider diversification and hedging strategies to tame volatilities and hedge macro risks. The REM is highly correlated to the overall market (correlation coefficient of 0.69), but weakly or negatively correlated to other asset classes such as long-term Treasury bills and gold.

Thus, it is possible to build a combined portfolio consisting of two or three negatively correlated assets, such as long-term Treasury bills and/or gold and REM. The following example illustrates the simple use of such a strategy:

Portfolio 1: 100% REM

Portfolio 1: 90% REM + 10% VDE

Portfolio 1: 80% REM + 10% EDV + 10% IAU

As can be seen in the following two charts, with the addition of 10% EDV and/or IAU, the combined portfolio significantly reduced volatility in terms of standard deviation (from 22% to between 17% and 19%), the worst performance of the year (reduction of about 1/2 with the addition of EDV and IAU) and the maximum drawdown (from 57% to between 44% and 49%). The downside is that the dividend yield is also reduced slightly, as you can see on the second chart, but not that much.

Returns of the REM ETF

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REM portfolio income

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Final thoughts and other risks

Investors should be aware of the main potential risks before undertaking REM. Its current yield of 7.2% is actually lower than its historical average of around 30%. Its significant concentration risks and high leverage in its holdings will continue to lead to significant volatility risks.

Besides these risks, its 0.46% fee is also relatively high for a passively indexed fund. Its long-term total return is 1.3% CAGR since 2008 and 5.6% since 2009, when the Great Recession was ruled out. And therefore, the 0.46% fee is a big part of its return potential.

We do not own REM ourselves (our REIT exposure is provided by RNP). But in general, we apply the diversification and hedging strategies above, as you can see in our actual portfolio shown below. But holding a mixed balance of different asset classes, including EDV and IAU, our portfolio has consistently outperformed the market with much lower volatility, as detailed in our blog post here.

Survival Withdrawal Portfolio Holdings

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