If you want to generate income from high-yielding stocks without drastically increasing your risk, you may want to consider a mortgage real estate investment trust (REIT) exchange-traded fund (ETF) like iShares Mortgage Real Estate Capped ETF (REM -0.81%) Here's why.
A little less complex
As the name would suggest, mortgage REITs manage portfolios of mortgage debt and other mortgage-related assets. If that sounds pretty straightforward, let me tell you, it's not.
The value of some assets are affected by housing prices and the economy, while other will fluctuate based on prevailing interest rates. Some are very risky, others are fairly tame, and depending on each individual company's strategy and goals they may invest in one type of asset or several.
Understanding these differences and keeping up with market conditions to know which companies are primed to perform can be not only time consuming but downright confusing.
By investing in an ETF, and holding a basket of dozens of these companies, you can calm some of these concerns and know that your more broad exposure to the sector will smooth out a portion of the volatility while still providing a yield upward of 10%.
As you can see in the chart above, due to rising interest rates and a number of other factors, mortgage REITs like Annaly Capital Management got hammered in 2012 and 2013. However, despite Annaly being the largest holding in IShares Mortgage ETFs portfolio, the ETFs took significantly smaller losses in stock price because of their more diversified exposure.
An unpredictable industry
As an industry, mortgage REITs have been far from consistent. In fact, among IShares Mortgage ETF's top 20 holdings in May 2007, just three remain in the top 20 today.
To put that in perspective, imagine that in less than eight years 17 of the top technology companies would merge with other companies, go bankrupt, or perform so miserably they fell to the bottom of the industry.
Believe it or not, in the past it has been fairly common for mortgage REITs to grow to the top of the industry, get caught taking too much risk, blow up, and then get replaced by up and comers. A process I expect to continue well into the future.
The beauty of ETFs is that they follow an index. This means that when companies fall out of favor and new companies start to emerge the portfolio will adjust itself and you do not need to be on top of which companies are best positioned and which might be on the verge of bankruptcy.
One major concern
Though mortgage REIT ETFs do give investors broader exposure, the industry is not particularly deep. In fact, IShares Mortgage ETF's portfolio is made up of just 40 stocks.
This is compared to the Vanguard Healthcare ETF, which has 335 stocks, or Vanguard's Energy ETF, which has 167.
My issue with the lack of depth is that investors end up with a more concentrated portfolio -- which is exactly what we were trying to avoid. In fact, the five top holdings of both mortgage REIT ETFs I've mentioned make up a whopping 50% of their portfolios' total values.
For investors that do not have the time to follow individual stocks closely, IShares Mortgage ETF will still give you a more diverse exposure than individual stocks and the automatic portfolio management is a fantastic benefit in an industry that can be wildly unpredictable. For those reasons, I believe buying and holding IShares Mortgage ETF over the long term is one of the safest bets for investing in mortgage REITs.
