21st November 2007

Dear Investor,

Gauge the risk: mortgage funds can come in all shapes

Is there such a thing as too much money? Most of us would think not, but when large chunks of money are competing for a home, investors are often forced to take on more risk.

One area where this has happened in recent years is the mortgage fund market.

Australians are estimated to have more than $22 billion invested in mortgage funds, with the largest retail funds having assets of close to $2 billion.

The appeal of mortgage funds is simple. They provide a steady, regular income and should deliver a better long-term return than cash investments.

But traditional mortgage funds have been lagging the cash rate and the better returns are being generated by funds that pack more punch but also carry greater risks.

Morningstar performance figures for the past financial year show returns ranging from 5.19 per cent (Colonial First State's Bricks and Mortar Fund) to 9.46 per cent (Mirvac's AQUA High Income Fund).

The median return is 6.58 per cent. But comparing funds at the top and bottom of the ladder is more like comparing chop suey with mangos than apples with apples.

If a fund is showing returns of 9 per cent or more, according to Morningstar's Anthony Serhan, it is almost certainly lending against construction and development. Borrowers don't pay higher interest rates because they want to; they do it because lenders charge them a higher rate to reflect the loan's higher risk.

It's a point that was lost on many investors who bought debentures and unsecured notes with groups like Fincorp, Australian Capital Reserve and Bridgecorp, and inevitably some mortgage fund investors will miss it too.

This isn't to say that mortgage funds fall into the same basket as these collapsed property lenders. Investors in these schemes often put their money into unsecured or secondary securities that rank behind secured lenders.

Most mortgage funds insist on first mortgage security, and while they may be creditors of the collapsed groups, Standard and Poor's fund analyst, Peter Ward, says they should get out relatively unscathed without causing losses to their investors.

The fact that mortgage funds are generally well diversified and don't put big slabs of their money with one borrower, also helps.

But you still need to understand just how much risk your mortgage fund is taking on and what protections it has in place.

Standard and Poor's has just completed a report on 52 mortgage funds and found big differences in what's on offer.

The report states conventional mortgage funds have been suffering from "milking the same cow" as the banks. Competing for loans has led to lower margins and, in some cases, lower credit standards.

Morningstar's Serhan has reported that smaller mortgage players, especially, can't compete on price when the banks decide to buy market share.

They may be able to compete by establishing better relationships with borrowers, but some have chosen to move up the chain - to look at loans less fiercely contested by the banks.

At the same time, traditional mortgage funds have been showing less than spectacular returns.

S&P's report found they have increasingly underperformed bank bills, and Serhan says they have lost ground to newer listed debt investments (many of which are also a step or more up the risk scale).

Traditional funds still make up the bulk of the market, but the number of higher yield or higher risk products is growing to adapt to these market forces.

So is it a case of once bitten, twice shy? Take a lesson from Fincorp and avoid the higher yield mortgage funds like the plague?

Not necessarily. S&P gave four star ratings to four high yield mortgage funds and said they should generate better short to medium term performance than the traditional funds. But you need to do your homework.

Ward says some of the more dubious practices in the industry (and these can occur in both higher yield and traditional funds) include lending against the "on completion" value of development projects (which includes the developers' profit) rather than the cost of the project, plus related party loans, insufficient liquidity within the fund, and high gearing levels. He says funds should be well diversified (geographically, across sectors and across borrowers), have a stable management team, and effectively manage arrears and defaults.

You also need to understand what the fund invests in. Ward says some mortgage funds have become hybrids and invest in fixed interest securities as well as mortgages, and there has been a rise in the number of residual product loans where mortgage funds lend against unsold units when a development is completed, in anticipation of the units being sold. As with development loans, interest on these loans is usually capitalised and represents higher risk.

S&P found widespread use of mezzanine finance (where higher geared loans are split, with the senior lender taking a first mortgage and other lenders providing additional finance) and some funds specialised in areas such as low or no doc lending.

If understanding all that sounds like hard work, you're right. Mortgage funds have become more complex and investors are further hampered by poor or inconsistent disclosure.

While he believes mortgage funds have a role in investors' portfolios, Serhan says they should provide standardised disclosure so that investors can compare risks between funds and understand measures such as the level of a fund's arrears. They may still not be comparing apples with apples, but at least it would look a bit less like chop suey.

Source: Sydney Morning Herald Date: 14/07/2007

Best regards,
Chris Andrews


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Chris Andrews
Head of Funds Management

t  +61 3 8610 2811
e  candrews@latrobefinancial.com.au

Chris Andrews is the Head of Funds Management for the La Trobe Group and has responsibility for the La Trobe Australian Mortgage Fund.
Read full profile here.

La Trobe is one of Australia's leading independent specialist mortgage Financiers. Its business includes residential mortgages, commercial mortgages, and investment services operating one of Australia's largest Mortgage Funds under AFSL 222213. It employs over 115 staff and has raised over AUD$10Billion to assist over 100,000 customers since inception in 1952.

Copyright 2010 La Trobe Financial. All rights reserved. No portion of this may be reproduced, copied, or in any way reused without written permission from La Trobe Financial. Disclaimer

* La Trobe Financial Asset Management Limited ABN: 27 007 332 363 and AFSL No: 222213 is the issuer and manager of the La Trobe Australian Mortgage Fund. It is important for you to read the Product Disclosure Statement for the Fund before you make any investment decision. You can get a copy of the PDS by calling 1800 818 818. You should consider carefully whether or not investing in the Fund is appropriate for you.
(1) The rates of return from the Fund are not guaranteed and are determined by future revenue of the Fund, and may achieve lower than expected returns. Past performance is no guarantee of future performance. Investors risk losing some or all of their principal investment.
(2) Withdrawal rights are subject to liquidity and may be delayed or suspended.
(3) As at 30/11/10 the La Trobe Australian Mortgage Fund had received a Morningstar RatingTM of 5 stars. The Morningstar Rating is an assessment of a fund's past performance - based on both return and risk - which shows how similar investments compare with their competitors. A high rating alone is insufficient basis for an investment decision. © 2010 Morningstar, Inc. All rights reserved. Neither Morningstar, nor its affiliates nor their content providers guarantee the above data or content to be accurate, complete or timely nor will they have any liability for its use or distribution. Any general advice has been prepared by Morningstar Australasia Pty Ltd ABN: 95 090 665 544, AFSL: 240892 (a subsidiary of Morningstar, Inc.), without reference to your objectives, financial situation or needs. You should consider the advice in light of these matters and, if applicable, the relevant product disclosure statement, before making any decision. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/fsg.pdf
(4) 3.75 star rating out of a possible 5 star rating indicates that Adviser Edge believes that La Trobe has performed in line with its peers and exceeded its peers on some fronts.
(5) The Standard and Poors rating of 4 out of 5 stars indicates that S + P has high conviction that La Trobe Financial will consistently generate risk-adjusted fund returns in excess of its relevant investment objectives and relative to its peers.
(6) The award was given to the La Trobe Australian Mortgage Fund, Pooled Mortgages Option.
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