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First Trust Plans For A Mortgage REIT ETF

The year has been marked with ups and downs for mortgage REITs that provide real estate financing through the purchase of mortgages and mortgage-backed securities (MBS). Volatile markets triggered by global growth worries and a stronger dollar weighed on these REITs. However, dovish comments by Federal Reserve Chair Janet Yellen while addressing the Economic Club of New York earlier this week along with the Fed’s March meeting, where the federal funds rate was dialed back to 0.875% by the end of the year from the previously expected 1.375%, provided a boost to rate sensitive sectors like the REITs (read: ETF Winners & Losers Following Yellen Comments ). A low interest rate environment is expected to benefit the performance of mortgage REITs. These REITs finance their investments with equity and debt capital and generate profits through the spread between interest income on mortgage assets and funding costs. Lower interest rates would certainly aid their borrowing cost, pushing earnings and dividends higher. Encouraged by this, First Trust has recently filed for an actively managed ETF, The First Trust Strategic Mortgage REIT ETF, targeting this market. While a great deal of the key information, such as expense ratio and ticker, was not available in the initial release, other important points were released in the filing. We have highlighted those below for investors who may be looking for a fresh out-of-oven play targeting the mortgage REIT segment from First Trust should it pass regulatory hurdles (see all Real Estate ETFs here ). Proposed Fund in Focus As the name suggests, the fund will primarily invest in individual mortgage REITs, which rely on the spread between short-term borrowing costs and the investment yield earned on longer-termed investments. This is in stark contrast to equity REITs, which earn generally from rent revenues coming from owned real estate properties. Apart from mortgage REITs, the fund may also invest in mortgage-backed securities and exchange-traded and over-the-counter (OTC) options on mortgage REITs and real estate companies, OTC options on mortgage TBA transactions, exchange-traded U.S. Treasury and Eurodollar futures, exchange-traded and OTC interest rate swap agreements and exchange-traded and OTC options on interest rate swap agreements among others. The fund may even engage in short sales as part of its overall portfolio management strategies. As per the SEC filing , the fund’s objective is to generate high current income. It will select its investments based on a top-down approach involving macroeconomic views on the sector with a bottom-up approach involving quantitative and qualitative analysis of individual securities. The fund also has an eye for limiting volatility and mitigating mortgage REIT valuation pressures using interest rate and spread based hedges. How does it fit in a portfolio? This fund can be a good choice for investor having faith in Yellen’s dovish comments that only gradual increases in the federal funds rate are likely in the coming years given the uncertain economic environment, employment scenario and inflation goals. Apart from that, the fund is also recommended for investors looking to diversify their portfolio to include the mortgage REIT segment. However, the fund on its own does not provide diversification benefit as it focuses on a single industry or sector and would be associated with higher concentration risk as compared to a fund that is broadly diversified over several industries or sectors. ETF Competition The First Trust Strategic Mortgage REIT ETF definitely holds promise. Still, there are a number of U.S.-based ETFs that are worth mentioning. A couple of the top U.S. mortgage REIT funds include the iShares Mortgage Real Estate Capped ETF (NYSEARCA: REM ) and the Market Vector Mortgage REIT Income ETF (NYSEARCA: MORT ). REM tracks the FTSE NAREIT All Mortgage Capped Index. The fund consists of 38 securities in its basket while it charges investors 48 bps a year. The product has amassed around $765.7 million in its asset base and trades in an average volume of 1.1 million shares per day. It has a solid yield of 11.9%. On the other hand, MORT tracks the Market Vectors Global Mortgage REITs Index. The fund consists of 26 stocks and charges 41 bps in investor fees per year. The fund is relatively less popular with an asset base of $95.3 million and an average volume of roughly 36,000 shares per day. It has a dividend yield of 9.89%. Being an actively managed ETF, The First Trust Strategic Mortgage REIT ETF could command a higher expense ratio than REM and MORT. Thus, the proposed ETF, if launched, has a good chance of making a name for itself only if it manages to generate returns net of fees greater than the passively managed products in the mortgage REIT ETF space. Apart from these, The First Trust Strategic Mortgage REIT ETF could also face competition from the global mortgage REIT fund – the iShares Global REIT ETF (NYSEARCA: REET ) . Link to the original post on Zacks.com

In Which I Answer A Question About The Volatility ETNs

The prevailing wisdom on the volatility ETNs, VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ: XIV ) and iPath S&P 500 VIX ST Futures ETN (NYSEARCA: VXX ), is that XIV will rise over time and VXX will fall as long as the term structure is in contango more often than it’s in backwardation. A recently elapsed period, slightly longer than a year, makes apparent that’s not the case. Over the period from 2-Mar-2015 to 18-Mar-2015, both XIV and VXX experienced substantial net losses. VXX declined -27.5%, while XIV declined -29.9% (Figures 1 and 2). Figure 1. XIV prices Figure 2. VXX prices This loss for both ETNs over a prolonged period occurred while the term structure was in contango 73% of the time – 2.7X more often than it was in backwardation, as Figure 3 shows below. Why is that? Click to enlarge Figure 3. Percent Contango from 2-Mar-2015 to 18-Mar-2016 One way to answer this question is by reference to variance drain. I picked the period 2-Mar-2015 to 18-Mar-2015 for illustration purposes in this article because it happens that the average of percent daily returns over this period is very close to zero for both ETNs. You can see that in Figure 4 below, which shows running totals for the percent daily returns for the indexes of both ETNs. Running totals for each end at zero, which of course means that the average percent daily return was also zero. Click to enlarge Figure 4. Running total of daily percent changes. The concept of variance drain was introduced by Tom Messmore in the context of comparing investment advisors based on average yearly percent returns. In brief, average periodic returns is a mathematically incorrect basis for comparison, since percentage gains accrue multiplicatively, not additively. This is best explained by example. Suppose you invest $100 in asset X. On Day 1, its market value falls by 25%. However, on Day 2, it rises by 25%. The average daily rate of return is (-25% + 25%)/2 = 0%. But your investment has not returned to its original value. Instead, it is now worth: $100*(1-0.25)*(1+0.25) = $93.75 A 6.25% loss. Since multiplication is commutative, order doesn’t matter. Investment Y that performs inversely to investment X, gaining 25% on Day 1, then losing 25% on Day 2 will also lose 6.25%. In general, this can be expressed as: I 0 *(1-α)*(1+α) = I 0 -α 2 , where I 0 is the initial investment. Clearly, the larger α is, the greater the net loss. Note that variance drain is not an actual loss. There’s no counterparty to variance drain. Nor is it a frictional drag in the sense that fees or leverage cost are. Rather it’s a demonstration that average periodic returns do not represent longer-term returns over multiple periods. In the case of the volatility ETNs XIV and VXX, the inverse relationship of their daily percent returns simply does not carry over to longer time periods, except by chance. What this means is that the question of why both XIV and VXX lost value, which several readers have raised in the comment sections of recently published articles on the volatility ETNs, is only a question if one starts from an incorrect assumption – namely that XIV and VXX are inversely correlated over time periods longer than one day. Since they’re not, both may lose value over time. Additionally, during time periods longer than one day when one loses as the other gains, those changes should not be expected to be equal and opposite. It’s also worth noting that excess of contango during this approximately one-year period did not result in XIV gaining value. On the contrary, it lost a substantial amount of its prior value. I’d like to encourage those who trade these ETNs to be certain the risks are well understood. Among those risks is the risk of placing too much faith in axioms and strategies that were formed during a period when the VIX was generally calm and declining. They may not apply during prolonged periods when the VIX is rising or is more frequently spiking. Disclosure: I am/we are long XIV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: I may initiate or close a long or short position in any of the volatility ETNs over the next 72 hours.

Q1 Asset Class Returns

The first question we had to ask ourselves after looking at the returns in March was, “Are the asset classes becoming increasingly correlated?” Here’s what happened in March by the numbers: 7 of the 8 Asset Classes recorded positive returns in March 4 of the 8 Asset Classes posted significant returns in March (Above 4%) 10.32% – The return of Real Estate in March 4 – Number of slots Real Estate moved up in the asset class scoreboard after March 2nd place – Where Managed Futures currently ranks despite a down month in March Real Estate: A double-digit return in a month is something you cannot ignore. What’s with Real Estate? The ETF we use (NYSEARCA: IYR ) tracks 100 different real estate companies , but the rebound could have something to do with another asset class… bonds (interest rates). Bonds: Depending on what Bond Market you watch, it was a big month. With the ETF we use is only up around 3% on the year, but the High Yield bonds cracked the Top 25 for best all-time monthly performance {Disclaimer: Past performance is not necessarily indicative of future results}. For those that have been following along the low interest rate environment we’ve been living in for almost a decade, low interest rates are good for people looking to purchase a home or refinance their mortgage. World Stocks, U.S. Stocks, and Commodities: Is the fact that these three asset classes all moved in tandem in March a coincidence or are these markets showing their true colors or being highly correlated? Last Week, we charted the current rolling 30 day correlation of the S&P 500 has to Crude Oil and not only has the correlation been increasing, 2016 has shown the highest correlation over a two year period. Managed Futures: Finally, Managed Futures had a tough month with the U.S. Dollar experiencing a choppy downward market. Combine that with the $VIX returning to the lows we saw constantly throughout 2014 and some of 2015 , and it was a struggle for managers to capture trends in choppy markets. We know the managers that we work with were long commodities but late reversals in the markets took away any gain made earlier in the month. The good news is that combined with the strong first two months of 2016 is enough to keep Managed Futures in 2nd place, despite a down March. Here’s the full look at the Q1 performance of 8 asset classes. Click to enlarge Click to enlarge (Disclaimer: past performance is not necessarily indicative of future results.) Source: All ETF performance data from Morningstar.com Sources: Managed Futures = SGA CTA Index, Cash = 13 week T-Bill rate, Bonds = Vanguard Total Bond Market ETF (NYSEARCA: BND ), Hedge Funds= IQ Hedge Multi-Strategy (NYSEARCA: QAI ) Commodities = iShares GSCI ETF (NYSEARCA: GSG ); Real Estate = iShares DJ Real Estate ETF ( IYR ); World Stocks = iShares MSCI ACWI ex US Index Fund ETF (NASDAQ: ACWX ); US Stocks = SPDR S&P 500 ETF (NYSEARCA: SPY )