ZROZ PIMCO 25 Plus Yr Zero Coupon US Treasury Index ETF

After much deliberation, the Federal Reserve finally announced the third round of quantitative easing or QE3, in an attempt to facilitate consumption in the economy thereby creating more jobs. The methodology utilized purchase of $40 billion worth of mortgage backed securities per month while keeping the tenure open-ended as a way to hopefully jumpstart the economy.

During this time, there were many products from the ETF space which hogged the limelight with everybody talking about the bullish impact of QE3 on these ETFs. These products were mostly 1) Commodity ETFs (particularly precious metal ETFs), 2) Mortgage REIT ETFs, and 3) Long Term Treasury ETFs.

The following table summarizes the absolute returns of some of the products from each of the above mentioned space, post the announcement of QE3 since all of these ETFs were expected to outperform other genres of ETFs in this environment.

Table 1: ETF Returns Post QE3 announcement

 

ETF	Fund Type	Returns
GLD	Precious Metal (Gold)	1.01%
SLV	Precious Metal (Silver)	2.39%
MORT	Mortgage REIT	-7.63%
REM	Mortgage REIT	-8.73%
DBP	Precious Metal (Multiple)	1.13%
JJP	Precious Metal (Multiple)	0.60%
GLTR	Precious Metal (Multiple)	1.33%
VGLT	Long Term Treasury	2.16%
EDV	Long Term Treasury	3.08%
ZROZ	Long Term Treasury	3.22%

Data as of November 23^rd 2012

Although it has been just about three months since the implementation of QE3, yet the performance analysis of these ETFs reveal important factors. As indicated by Table 1, most of these perceived ‘outperformers’ have had mixed results so far. While some of them have lost substantially, others are almost flat or have generated paltry returns.

Precious Metals ETFs

Probably one of the biggest beneficiaries of the impact of QE3 was expected to be the precious metals asset class, particularly Gold. As a result of the monetary easing, the U.S. dollar was supposed to lose value thanks to the Fed’s money printing spree. This was perceived to pave the way for precious metals to be the safer havens instead of the U.S dollar.

However, the performance of precious metals suggests that they have clearly failed to live up to the hype. This is disappointing especially considering certain events, apart from QE3, which were supposed to push the price of the yellow metal upwards (read Protect Against QE with these Precious Metal ETFs).

Emerging economies like India and China together account for a majority of total global gold consumption. Thus, the consumption demand for gold in these economies is one of the major price drivers in the global markets.

However, considering the conclusion of the festive season in India where gold consumption is at its peak, the prices were expected to climb upwards, which has clearly not happened.Also, the investment demand for gold was expected to rise across the board given its safe haven nature amidst global economic uncertainties.

Yet, the precious metal has disappointed on this front as well. The largest and most popular Gold ETF, the SPDR Gold Trust (GLD), has been almost flat since the announcement of QE3 and has returned only 1% since then (see more in the Zacks ETF Center).

On the other hand, the consumption demand for silver has been on the rise as well, mainly thanks to its vast industrial usage as opposed to its yellow counterpart. The manufacturing data from the U.S. and China have been moving higher as of late, due to the moderate recovery in the global economy. As a result the industrial consumption of silver has increased, mainly thanks to the Chinese demand, which has in turn helped to push the prices up.

The iShares Silver Trust (SLV) has returned 2.30% since the announcement of QE3. Also, some other precious metal funds like PowerShares DB Precious Metals ETF (DBP) which invests 80% of its assets in Gold and 20% in Silver has been flat at 1.13%. Similarly the iPath Dow Jones UBS Precious Metals Sub Index Total Return ETN (JJP) tracking 76% Gold and 24% silver has fetched 60 basis points for the same time period primarily due to their concentrated focus on gold.

Outlook

While the performance of the precious metals so far has been disappointing, it is prudent to note that the quantitative easing has yet to show its full effects. Also, with the fiscal cliff issues looming large, the depreciation in the U.S. dollar as well as paltry low yields of the Treasury bonds, it is inevitable that gold is all set for a reversal in the near term.

Gold is expected to go back to being the ultimate safe haven, especially with the fiscal cliff deadline less than a month away from now (see A New Breed of Gold ETFs on the Horizon?).

Mortgage Real Estate Investment Trust (mREIT) ETFs

The ETFs from this segment are especially known for their high yields and stability and have been extremely popular given the low interest rates and stock market volatility. These ETFs, like their MLP and pure REIT counterparts, pay out 90% of their net income as dividends in order to corporate level taxation — a fact which explains the high dividend yields (read MLP ETFs: Unfortunate Victims of The Fiscal Cliff).

REIT ETFs were perceived to be big gainers post QE3 as the monetary easing was supposed to bring down yields further, thereby making the higher yielding REIT space an attractive one. However, the higher yielding asset classes, especially REIT and MLP ETFs were victims of the huge sell-off after the U.S presidential elections.

This was due to the uncertainties pertaining to the tax issues on dividends as well as capital gains. Thus, investors rushed to liquidate their position in order to be taxed at the current tax rates.

As a result the Market Vectors Mortgage REIT ETF (MORT) and iShares FTSE NAREIT Mortgage Plus Capped ETF (REM), two ETFs from the mortgage REIT space have slumped by 7.63% and 8.73% respectively.

However, both these ETFs had enjoyed a decent run till the fiscal cliff panic sell-off post the presidential elections. MORT and REM have a 12 month distribution yield of 9.91% and 11.91%.

Outlook

Although the higher yielding ETF space is all set to remain volatile till the fiscal cliff situation is resolved and we have clarity over tax issues, yet there is no denying the fact that REIT ETFs are great options for income seeking investors in this ultra low interest rate scenario.

Also, a possible increase in tax rates across the board could be a blessing in disguise for the Mortgage REIT space, since REIT ETFs are already taxed at ordinary income levels as capital gains since the dividends from REIT and MLP ETFs are not taxed when the distributions are made.

Therefore even if the tax rate does increase on an incremental basis, mREIT ETFs will encounter relatively less tax rates than most high yielding investment avenues making them far more attractive investment avenues for income seeking investors.

With this backdrop it is prudent to note that once we have some sort of transparency on the fiscal cliff, these high yielding ETFs will be back in the limelight (see Is the Panic Over for Mortgage REIT ETFs?).

Long Term Treasury ETFs

Apart from the implementation of QE3, the Fed has also extended operation twist which aims at reducing long term borrowing costs. Apart from its positive consequences such as stimulation of, and facilitating growth in the economy, it could also result in a Japan like situation with stagnant growth rates and threats of deflation.

Whatever the economic effects of such measures, it is quite clear that Treasury bonds, especially the longer dated ones, have benefited substantially despite their frustratingly low yields. This has happened due to two primary reasons.

First, these bonds have continued to act as the safe havens during the severe market volatility over the past 18 months. Second, there is a negligible probability that interest rates will increase in the near to medium term. Thus the possibility of losses from these instruments due to their high duration is very low, at least in the near term (see Long Term Treasury ETFs: Ultimate QE3 Play?).

In fact, ETFs from this space are among the biggest gainers post the announcement of QE3. The Vanguard Long Term Government Bond ETF (VGLT) with effective duration of 16.48 years, Vanguard Extended Duration Treasury ETF (EDV), with effective duration of 26.30 years and PIMCO 25+ Year Zero Coupon U.S. Treasury ETF (ZROZ) with an effective duration of 29.88 years have returned 2.16%, 3.08% and 3.22% in that time frame.

Outlook

Interest rates will clearly continue to be at depressed levels for quite some time. Coupled with the clear deceleration in corporate sector earnings in the third quarter earnings season and the looming fiscal cliff — all of which are matters of concern for the economy, long term Treasury ETFs will surely be in high demand as the outlook for the riskier asset class is pretty volatile if not completely bearish (read 3 ETFs To Prepare For The Fiscal Cliff).

Also, given a probable dividend tax increase, the paltry yields of these instruments will insulate them from paying more taxes as these long term treasury ETFs are not expected to pay much in the form of dividends thereby making them attractive plays even if we fall off the cliff.

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PWRSH-DB P METL (DBP): ETF Research Reports
 
VANGD-EX DUR TR (EDV): ETF Research Reports
 
SPDR-GOLD TRUST (GLD): ETF Research Reports
 
ETFS-PH PRC MTL (GLTR): ETF Research Reports
 
IPATH-DJ-A PR M (JJP): ETF Research Reports
 
MKT VEC-MTGE RE (MORT): ETF Research Reports
 
ISHARS-F N MTG (REM): ETF Research Reports
 
ISHARS-SLVR TR (SLV): ETF Research Reports
 
VANGD-LT GOV BD (VGLT): ETF Research Reports
 
PIMCO-25Y ZERO (ZROZ): ETF Research Reports
 
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