The changing face of mortgage funds

Quality mortgage funds have always been considered a good asset class for providing regular income while at the same time offering the security of a diversified property portfolio backing income-earning mortgages.

There are a number of reasons for their ongoing appeal.

One reason is that, as history shows, in times of economic downturn it is the products that are loaded with risk that are most likely to collapse first. These are the products that also give the very highest returns and have no real asset backing. However, mortgage funds have stood the test of time.

But, along with other asset classes, there have been many changes in the mortgage funds area in recent years, with the release of a number of new products with different characteristics.

These differences are not always understood by investors, who may think all mortgage funds are the same. As a result, investors may be taking on more risk than they intend to, or not getting the returns they are after.

Australian Unity Investments (AUI) has been making the point for some time that managing risk is essential if mortgage funds are to continue to provide diversity and add value to investors’ portfolios.

With pressure on debt, the strength of some mortgage funds could be tested if their managers have not been disciplined in risk management or have overlooked diversification as a key criterion when constructing portfolios.

Good quality mortgage funds that have disciplined risk management processes and diversity are likely to have a track record of low levels of borrower defaults. This is because of the quality of the properties behind the mortgages and the diversification of lending through property category and geographic spread.

Regardless of the different kinds of funds available, their investment criteria and rate of return, investors should always remember it is still necessary to choose a highly rated, well-managed mortgage fund with a consistent performance track record.

For example, mortgage funds that sit on large cash holdings are hard to justify to investors who are paying for their investments to be professionally managed.

Large cash holdings also make it difficult for a manager to achieve performance benchmarks. Mortgage funds should aim to have at least 70 per cent of their assets invested in mortgages to maintain performance.

One outcome of the number of new entrants in the market has been the increasing categorisation of mortgage funds according to their investment approach and risk level.

The three main categories are:

~ Conservative funds.These are the more traditional mortgage funds, which should be almost fully invested in first-mortgage loans over commercial properties, ideally with a 70 per cent (or better) loan-to-valuation ratio. Such funds usually provide regular returns and a high level of security and, as a result, their returns tend to be at the lower end of the scale. These were the first funds available to investors in this asset class, and some of the better funds have been operating for well over a decade.

~ Hybrid funds. These funds include non-mortgage backed fixed interest assets such as cash and corporate debt, as well as mortgage-backed securities. Generally, the non-mortgage investments can account for up to 50 per cent of the fund. While this approach allows the manager to generate higher returns, it can also add to risk.

~ High-yield funds. These funds may include second mortgages, which can also be referred to as mezzanine finance. They may also have exposure to a higher level of construction, development or specialised lending, which may reduce the diversification levels of the fund and further increase risk. However, in recent times they have been attractive to many investors due to the higher levels of return they can achieve. Importantly, disciplined fund managers operating larger funds can still achieve adequate diversification. Our view is that this type of fund should have similar risk management and diversification attributes to the more conservative mortgage funds.

Because of the range of mortgage funds that have emerged, investors need help from their advisers to understand what constitutes a good quality product. They need to know the difference between the various mortgage funds on the market, as well as their management style, so they can better understand the risk profile in a particular fund and not just focus on returns.

Going for the highest possible return without looking at risk clearly doesn’t make sense.

Fixed interest returns are likely to increase in 2007 anyway through rising interest rates, but wise investors will avoid being greedy and ignore products that produce 3 or 4 per cent above average returns.

The Westpoint collapse brought to the forefront the risk of chasing high returns from a product investing in a single property managed by a single developer who is also the fund manager.

It is always worth looking at the fund manager. The experience and commitment of the organisation and the resources they have put behind the fund need to be checked, as well as the loan security, diversification of portfolio and risk management techniques used.

Investors should be confident about the style of the product and the manager’s ability to provide well-managed products that outperform. An extra 1 per cent, or even 0.5 per cent, above the bank bill index will make a significant difference to a year’s income for a retiree.

For advisers, the responsibility is always to make sure clients know what they are investing in. This includes being confident the fund is true to label and understanding which category the fund falls into. While human nature suggests investors always want the highest yield, the level of risk must be clearly understood by clients and agreed to. A lesson reinforced by the Westpoint failure is that investors blame the adviser when anything goes wrong.

There are five points that we would recommend advisers check with clients when they are considering any income product.

1. If returns seem too good to be true, then they probably are. It is a statement of the obvious, but often forgotten by clients, and they need a constant reminder. For example, at AUI we believe double-digit returns, or even returns approaching this, from mortgage funds are almost impossible to achieve without an unacceptable level of risk.

2. The ‘loan to valuation’ ratio (LVR) should be no more than 70 per cent for conservative funds and 85 per cent for high yield funds. The LVR is always a good indicator of a mortgage trust’s risk profile and well worth discussing with clients. For mortgage funds, this ratio compares the value of all loans against all properties in the fund and should be provided in the fund’s Product Disclosure Statement. The lower the ratio, the more equity available for investors if problems do arise.

High yield mortgage trusts set out to produce bigger returns than conservative funds, so they do come with more risk. LVR is one indicator of how much more.

3. What are the investor entitlements? Conservative mortgage funds hold only first mortgages, while more risky funds, such as mezzanine funds, largely invest in second mortgages in one development to produce a higher rate of return. This means investors in mezzanine funds are further down the list of creditors if anything goes wrong, and run a much higher risk of not getting any of their money back. High yield mortgage funds sit somewhere between these two extremes, with the well managed funds closer to the conservative end. They therefore offer slightly higher returns with a little more risk.

4. Consider the spread of loans. If a fund allocates 50 per cent or more of the portfolio to construction and development loans, then alarm bells should sound.

A well-balanced mortgage fund should only have a small proportion of loans in the development area, and also have a spread of loans against different property sectors — including residential, commercial, retail and industrial. A good geographic spread around Australia adds further to diversity.

5. Check what the experts say. Use ratings when talking to clients. Researchers’ data can be used as a very reliable source of third party information to help clients understand a product and its features.

The way products are rated also helps comparison with similar funds.

Roy Prasad is head of mortgages at Australian Unity Investments.