9th January 2008
DON’T INVEST BASED ON RATE ALONE
We’ve all read the newspaper advertisements where the claim reads something like, “EARN UP TO 8.50%p.a.”, or “9.75%, 11.25%; even up to 18%p.a.”. With these kinds of returns you know there must be a catch somewhere, but it’s also these returns that make an investment opportunity seem so attractive. After all, you are investing your hard earned dollars, so don’t you deserve the highest possible rate of return on your investment?
You may be wondering why a high income fund was not part of your recommended investment portfolio from your accountant or financial adviser. It is important that we explain the reasons for this, especially because of the recent popularity of such products.
Risk and Reward
You’re no doubt aware that with most forms of investment, there is a trade off between risk and reward; low risk products such as cash investments offer lower returns than high risk products which offer higher returns, such as shares.
Background to higher income funds
Let’s take a look at higher income funds. In general, these income funds are mortgage funds, utilising slightly riskier mortgages. How does an investor in an income fund generally earn a return? As its name would suggest, an income fund pays income or distributions expected to be at regular intervals, monthly or quarterly. Essentially, the income to the investor is generated by the fund holding mortgages over land and properties of borrowers. These borrowers need to repay borrowed monies plus interest.
In another way, think about the income paid to investors being less than what the fund manager and/or product provider would be receiving. You would expect the difference to be around 1.5 to 2%p.a.
High income funds are influenced by a number of factors, some of which differ and some may be outside of the control of the manager. Potential risks can impact on the future level of income and the proportion of capital returned to the investor at the conclusion of the investment term.
Some of the risks include:
- Macroeconomic risks such as:
- national growth levels,
- interest rates and inflation
- Industry risks
- Specific risks in the operation of the fund, including:
- possibility of loan defaults by borrowers,
- inaccurate valuations,
- falls in the value of properties used as security
- Furthermore, with development loans there is the risk of project non completion.
Some common themes in high income funds
Looking at product specific risks, let’s now consider what sort of assets - the types of mortgages are brokered – that fill this high income product space. The telling statistics appear when you look behind the “EARN UP TO 8.50%p.a.” offers. A quick survey among the Product Disclosure Statements and monthly fact sheets of high income funds display a number of common themes:
- Relatively high average loan sizes of at least $2.5 million to $3.0 million.
- A surprising proportion of mortgages over vacant land, sometimes as high as a third of the portfolio.
- Little or no mortgages over commercial properties, industrial or retail properties. If there are, then tourism and hotels are most common.
- Normally, the greatest proportions of mortgages are over residential developments, canal complexes and apartment building dwellings.
- The final defining feature of such mortgage funds is their regional concentration. For Example, Southeast Queensland can occupy over 70% to 80% of the fund manager’s mortgage portfolio.
The bottom line
When you consider these features, you can begin to get a clearer picture of why high income funds are not normally part of an ‘approved product list’ for financial planners. Such products can display many risky features that may result in an increased probability of capital loss to the investor.
A SUMMARY OF THE RISKS OF HIGH INCOME FUNDS
- High risk products: risk of capital loss from default; risk of under-performance.
- Average loan to value ratios are allowed to balloon to 80%, (normally kept to 66% by
mainstream fund managers).
- Loans are generally concentrated in one region.
- Mostly, these products have a high proportion (up to 80%) of loans to residential development projects.
- Few product providers, mainly small localised organisations that are often not researched.
- Some product providers have claimed zero default ratios. Can this history continue in
different market conditions?
- Some of these products only offer select (as opposed to pooled) mortgages, which are riskier by construct due to lack of diversity in the loan portfolio.
- Some of these products offer >15%p.a. returns from select first and second mortgages. Second mortgages have another added layer of risk.
- Boutique mortgage managers may lack adequate corporate strength, robust administration and back office support, and high customer service standards.
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Head of Funds Management
t +61 3 8610 2811
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.
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