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First Trust Enters MBS Space with Low Duration ETF (LMBS)

Zacks Equity Research

First Trust is famous for its unique approach under which the issuer looks to offer better or more targeted exposure to a given asset class. Of late, the issuer has been beefing up its portfolio with fresh-themed products in a space which it has already entered and exploring new arenas as well.

Such a maiden zone is the mortgage-backed securities space. The issuer has come out with a brand new product – First Trust Low Duration Mortgage Opportunities ETF (LMBS) – the first such mortgage-backed securities (MBS.V) fund for First Trust (read: Guide To MBS ETF Investing).

LMBS in Focus

The actively managed fund seeks to provide exposure to mortgage-backed debt securities and other mortgage-oriented products associated with residential and commercial mortgages, per the issuer. The fund involves securities with high investment grade with at least three-fifth of assets being government-sponsored and lower ‘expected price sensitivity to the credit cycle’. The fund charges 65 bps in fees a year for this exposure.

This approach results in the fund holding a basket of 36 securities. The portfolio’s average effective duration will typically be not more than three years. The portfolio is widely diversified with no product accounting for more than 2.20% of the basket. However, what makes the fund different from other MBS ETFs is that unlike other funds, LMBS seeks to limit the duration extension.

How Does it Fit in a Portfolio?

The fund is a good choice for investors seeking exposure to mortgage-backed funds to generate income and diversify their fixed income exposure. Investors should note that MBS normally yields higher than the Treasury bond with similar credit rating. Though the MBS space is not in great shape at present, mortgage volumes might pick up in the coming quarters as the economy perks up.

 As the demand for residential and commercial real estate rises, mortgage financing companies are bound to see an increase in their asset books in the near future. As per the issuer, every single year of the duration normally corresponds to a 1% likely shift in the value of a security for every 1% increase or decrease in interest rates.

As a result, with not more than three years of effective duration, the product appears less interest-rate sensitive in a rising rate environment which could be the case next year. Moreover, the issuer has also indicated that active management will also help in adjusting the duration should the interest rates rise (read: First Trust Launches New Short Duration Bond ETF).

ETF Competition

At present, the MBS ETF space has very few options, though the newly launched fund will certainly face competition from the largest two players in the space – iShares Barclays MBS Fixed-Rate Bond Fund (MBB) and Vanguard Mortgage-Backed Securities ETF (VMBS).
MBB rules the space with an AUM size of $6.58 billion and an average trading volume of more than 350,000 shares a day. The fund tracks the Barclays Capital U.S. MBS Index to provide exposure to investment grade fixed-rate mortgage-backed pass-through securities of U.S. agencies.

MBB charges 27 basis points as expenses. VMBS, however, manages an asset base of $645.1 million but is the cheapest in the space with an expense ratio of 12 basis points (see all Mortgage-Backed Security ETFs here).

On the other hand, the newly launched product charges pretty higher than both space toppers. In fact, LMBS’ expense ratio of 65 bps is also higher than the average expense ratio (29 bps per etfdb.com) of the mortgage-backed securities ETFs.  Thus, fees could be a hindrance to asset generation for the newly launched product. 

Nonetheless, if the newly launch fund is indeed successful in its attempt to limit volatility caused by duration risk, it might see great days ahead and manage to build a sizable asset base as well. So to win the game, the issuer needs to show off LMBS’ actively managed nature and outperform some of the more entrenched competitors in the space.
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