New ETN: High Yield with High Risk

Investing Daily Article of the Week

by Ben Shepherd, Featured Expert,  Investing Daily

Four new exchange-traded products were launched last week, but the one that yields almost 25 percent will likely attract the most attention.

ETRACS Monthly Pay 2X Leveraged Mortgage REIT ETN (NYSE: MORL) is an exchange-traded note (ETN) from UBS that offers a monthly coupon equivalent to twice the distribution rate of its index constituents.

Mortgage real estate investment trusts (REIT) are required by law to pay out at least 90 percent of their earnings to investors. Additionally, they typically borrow against their holdings of mortgage-backed securities to magnify their returns, and that use of leverage can result in eye-popping payouts. The average mortgage REIT currently yields in the low double digits, so that means this ETN offers a huge nominal yield of almost 25 percent once you factor in its double leverage.

Unfortunately, this ETN’s substantial leverage also poses a challenge for investors. For starters, its leverage resets at the end of each calendar month, so it will only accurately track its underlying index for one month at a time. Over longer-term periods, the ETN’s performance will deviate sharply from that of the index.

And the ETN’s leverage is applied on top of the aforementioned leverage that most mortgage REITs employ to juice the returns of their own holdings. So that means investors in this ETN are technically exposed to even greater leverage than the double leverage specified in its mandate. Beyond that, the ETN’s holdings can suffer significant volatility when interest rates change, or even when there’s merely a shift in expectations about future interest rates.

As a result of the real estate crash, many of the mortgage REITs that took on inordinate amounts of credit risk soon found themselves out of business. Most of the mortgage REITs that remain standing focus primarily on interest rate risk; they use cheap financing to buy mortgage-backed securities issued by Fannie Mae and Freddie Mac and profit from the spread.

Although credit risk isn’t a major concern for most mortgage REITs at this point, any uptick in interest rates will likely trigger big downside moves.

The note currently tracks a basket of 25 mortgage REITs, though its performance will be largely tied to Annaly Capital Management (NYSE: NLY) and American Capital Agency Corp (NSDQ: AGNC), which account for 20 percent and 15 percent of assets, respectively.

The fund charges a 0.35 percent annual expense ratio.

For those investors interested in mortgage REITs, but concerned about the risk inherent in a leveraged ETN, there’s actually a less volatile option available.

Market Vectors Mortgage REIT Income ETF (NYSE: MORT) tracks the same index as MORL, but with two key differences: It’s structured as a traditional exchange-traded fund (as opposed to an ETN), and it doesn’t employ any leverage. Though its yield is significantly lower, it’s still an impressive 9.4 percent.

PowerShares S&P 500 High Dividend Portfolio (NYSE: SPHD) was also launched last week.

Given the current low-income environment, investors have flocked to products that offer high yields. But this fund goes one step further by selecting the highest yielding names that have exhibited the least amount of volatility.

To build this fund’s portfolio, PowerShares first identifies the 75 S&P 500 components that pay the highest dividends over the trailing 12 months. It then selects the 50 names that traded with the lowest volatility over that same period.

From there, each stock is then weighted according to its dividend yield, with the highest yielders receiving the heaviest weightings.

Even so, the fund’s top 10 positions account for only about 25 percent of total assets, with the highest single stock weighting running about 3 percent. Its current top positions are Windstream Corp (NSDQ: WIN), Pitney Bowes (NYSE: PBI) and CenturyLink (NYSE: CTL), each of which top out at about 3 percent of assets.

For now, the fund definitely favors smaller companies, with about 45 percent of assets allocated to mid-caps. Utilities account for about 22 percent of assets, followed by consumer staples (16 percent), financials (13 percent) and telecoms (10 percent).

The fund charges a 0.30 percent annual expense ratio and should yield about 4.5 percent.

EGShares Emerging Markets CORE ETF (NYSE: EMCR) was launched last week by Emerging Global Advisors.

The fund takes a “core” approach to emerging market (EM) investing by spreading its assets across all industries according to their share of economic activity. Its largest allocations are consumer discretionary and staples (each about 17 percent of assets), financials (16 percent), industrials (10 percent) and utilities (7 percent). From there, technology, energy, health care and materials each receive allocations of about 6 percent of assets.

Indian, Chinese and South African companies each account for about 15 percent of assets (the maximum country allocation), and Brazil receives a 10 percent weighting. The fund’s remaining assets are spread across Russia, Chile, Malaysia and Mexico.

The fund charges a 0.70 percent annual expense ratio.

Finally, Vanguard Short-Term Inflation-Protected Securities ETF (NSDQ: VTIP) began trading last week.

The ETF’s portfolio holds short-term Treasury Inflation-Protected Securities (TIPs) with maturities of less than five years. It currently maintains an average duration of 2.7 years. This fund offers a decent hedge against inflation, while keeping a lid on interest rate risk.

The ETF’s annual expense ratio is 0.10 percent, which is half that charged by competitors managed by iShares and PIMCO.

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