Boost your cashflow with mortgage funds

Individual investors can now more easily access mortgage funds, an investment opportunity that has traditionally only been available to institutional investors and high net-worth individuals, and benefit from the regular income and diversification advantages these funds deliver.

Before allocating money to mortgage funds, however, it's important for investors to ensure that the fund manager has a strong track record in the asset class and a proven method for managing risk through market cycles.

How mortgage funds work

A mortgage fund is an investment product that is on-lent to borrowers who use the funds to buy or develop properties or for other investments. In return, the fund promises to pay investors a regular income with the interest paid by the fund's borrowers.

Investors typically allocate money to a mortgage fund because they want access to a regular stream of income and attractive rates of return, generated by a fixed, short- to medium-term investment, secured by real estate.

"Mortgage funds are becoming an increasingly popular investment with retail investors, sophisticated investors and self-managed super funds," says Morgan Ng, managing director, Maxiron Wealth.

Pooled funds

Mortgage funds come in two main categories: pooled and contributory funds.

A pooled fund is an investment vehicle through which multiple investors contribute funds that are used to invest in a diversified portfolio of mortgages.

The Maxiron Monthly Income Trust, for example, is structured so that the fund lends to a special purpose vehicle which on-lends to borrowers. For added security, the special purpose vehicle holds additional capital and promises to pay the trust a fixed rate of return.

Fixed-rate funds give investors exposure to a source of regular, passive income at a known target rate of return for a fixed term. Some funds also offer a variable rate of return, but investors have less certainty about the income their investment will generate with these funds.

Pooled mortgage funds may offer a range of short- to medium-term investment options, to allow investors to manage their cashflow requirements.

"These structures offer diversification benefits, as investors are able to spread their money across a pool of mortgages. This may reduce the risk because the money is apportioned over a number of loans, rather than simply being exposed to a single loan or borrower," explains Ng.

This diversification mitigates the risk of investors losing money in the event any borrowers default on a mortgage, as the other investments will continue to generate interest to pay investors a return.

More recently, pooled mortgage funds have become more accessible to investors, as options in this asset class have emerged that have a lower minimum investment amount than wholesale mortgage funds generally require.

These retail investment funds must meet stringent regulatory requirements to ensure investors' funds are properly protected and managed.

"This has opened up the mortgage fund opportunity to a larger group of individual investors," says Ray Saedi, executive fund manager, vice president, Maxiron Wealth.

The way funds work, provided the special purpose vehicle manages its loans well, is that investors earn interest regardless of the performance of the underlying loans, which may impact returns. They have no influence over where the funds are invested.

Contributory funds

By contrast, with a contributory fund, investors have direct control over where their funds are invested and can choose their level of exposure to particular properties.

The main disadvantage of contributory mortgages is that there is normally a smaller number of assets in the fund versus pooled funds, which increases risk on a relative basis, especially if any borrowers default.

With contributory mortgages, interest isn't usually paid until the loan has been fully funded. Plus, investors are normally required to allocate a large minimum amount - often hundreds of thousands of dollars - to these funds. This is because there is a limit to the number of investors who are part of the fund.

Additionally, contributory mortgages come with liquidity limitations. Each mortgage in the fund has different terms and conditions, so investors may not be able to access their capital on a short-term basis, with their funds tied up for months or years.

"You can't easily withdraw your investment until the loan is repaid by the borrower. This can be a problem if you need extra funds for unbudgeted expenses or emergencies," says Saedi.

As for the impact of different variables on performance, pooled mortgage funds with a fixed target return rate are often attractive to investors looking for investments whose returns are uncorrelated to the current economic cycle or interest rate movements.

This is because the unit price, rate of return and term are fixed. So, the target rate the fund earns doesn't change within the term of the investment, no matter where the cash rate cycle is.

Nevertheless, it's vital for mortgage funds to adjust their strategies to take into account current market conditions.

For instance, during periods of economic uncertainty, fund managers may shorten borrowing terms from 18 months to 12 months, for example. Or they may reduce loan sizes.

"This can increase the turnover of loans and reduces the risk of default or late payments," says Saedi.

What to consider first

Investors need to explore many factors before allocating money to a mortgage fund.

As a starting point, it is worth looking into the different types of borrowers in the fund.

For example, develop a picture of the credit quality of the entities whose loans are in the fund, the industries in which they operate and the type of properties to which the fund managers are prepared to lend.

The wider the universe of borrowers - for instance, a healthy range of different residential and commercial loans, and the industries and geographies of the properties in the fund - the lower the risk to investors.

It's essential to understand how the fund manager assesses borrower risk.

"Ideally, borrowers pay interest based on risk-adjusted rates. So, when borrowers are assessed as higher risk, they pay interest at a higher rate than borrowers who are assessed as representing a relatively lower risk," says Ng.

It's also important to unpack how the fund is governed. The best funds will have independent oversight and auditing - that is, the trustee is totally independent of the manager of the fund.

Do some research into the fund manager and management team's background and experience to develop a level of comfort about how the fund's assets are managed.

The key is to understand how the fund generates a return, manages risk and performs through the economic cycle. That's the best way to ensure the investment is aligned to your long-term investment goals and can help support your income and cashflow requirements.

This report is sponsored by Maxiron Wealth. It was independently researched and written.

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