4th March 2010
Again some media commentators are questioning the performance and the viability of the Mortgage Fund industry. La Trobe would like to bring a different perspective to the issues of investment performance and liquidity, particularly in light of our recent Money Magazine award as Australia's BEST MORTGAGE FUND and having operated since 1952, managing over $10 billion of investment funding.
La Trobe believes that commentators need to look more deeply to properly understand the underlying cause of the Mortgage Fund liquidity crisis triggered in October 2008. Mortgage Funds had generally forgone proper structuring of their investment products, primarily in the pursuit of growth. This was a common commercial choice but is not inherent in the Mortgage Fund asset class; successful alternate structures currently exist. This issue
also raises questions about investment product viability in the modern retail investment distribution industry.
In terms of investment performance, a low quality or inconsistent asset profile has clearly been a significant issue for the small number of Mortgage Funds that have materially downgraded returns in recent times. Fund managers, in differentiating themselves from these, will rightly emphasise superior asset selection profiles and management practices, and this differentiation
appears broadly valid across the sector to date.
The key asset quality differentials for the poor performers appear to be (1) the extent of large loan concentrations (in excess of $1 million), (2) their exposure to construction/development loans, and (3) excessive geographic location/ industry concentrations, which can all (especially in combination) lead to significant impairments for a Mortgage Fund during economic downturns.
The above causes a poor performance and in some instances may reflect too rapid growth in funds under management.
However of much broader importance over the last 18 months is liquidity in the Funds - investors' ability to get their investment back within the promised timeframes. To date we have seen no discussion of why so many Mortgage Funds were offering short redemption terms for investors, that is, high liquidity, on what is clearly a longer term asset base.
This is the issue common amongst all 'frozen' funds: an underlying mismatch between Fund assets (mortgage loans) and Fund liabilities (investors' money). Most Mortgage Funds have been taking 100% of their funding from short term daily redeemable/ "at call" investments and herein lies the structural problem.
It is true that some Mortgage Funds commenced "at call" liquidity many years ago and have managed this structure without freezing since then (albeit with lower investor returns as a consequence).
However over the last 10+ years these Mortgage Funds have proliferated and new capital invested in these funds (marketed as "at call" accounts) has mushroomed, creating the scale of event now being witnessed. Certainly in our view this funding is misplaced.
This situation has been contributed to significantly by rapid development of the managed funds industry (with huge inflows) over the same period, but aspects of this industry now appear to present a major hurdle to reform of the current situation.
A key aspect in this is the distribution model adopted by these Funds, linked to the move in recent years by the 'retail investment' distribution industry to manage investment products via
investment platforms. Platforms have the capacity to drive large volumes
to a Mortgage Fund but act to entrench the need for "at call" liquidity. Mortgage Funds have found attracting short term capital an easy way to grow their funds under management and have embraced the structure, sometimes then growing at rates that may have put sustained asset quality
What does this mean and what are the consequences:
- Platform operators have required short term liquidity of all investment products they distribute. Ordinarily this is convenient for investors and advisers (and for large financial institutions that own and control the platforms). Platforms are now a successful mainstay (and significant gatekeeper) of retail investment distribution in Australia.
- This is an excellent fit for assets that naturally provide such liquidity. Problems arise however where the approved products do not adequately provide such liquidity, as is the case for Mortgage Funds (most high profile amongst others).
- Mortgage Funds that have frozen were structured by managers to act as liquid investments, (thus gaining access to distribution on investment platforms). This is inappropriate because Mortgage Funds at their core are term investments, that is, the assets of the fund are generally 1-5 year loan receivables. Only through
cash holdings and standby liquidity facilities can this be modified for the investor, but overlaid liquidity is limited and is costly to investors.
- Mortgage Funds however also came to achieve very high fund under management growth by representing that they could accept funds which investors required to be highly liquid, ie money "at call" for daily living expenses. In truth, quite clearly this is not the place for such short term funds. As a result much short term capital was inappropriately placed (and then caught) in Mortgage Funds pretending to be enhanced cash trusts.
- It should be noted at this point that the exposures resulting from "borrowing short / lending long" should not be held out as a surprise to investment managers. Predictably however, an opportunistic exercise of finger pointing has ensued since October 2008, blaming primarily the government guarantee, but also rating agencies and investors themselves; all deflect from the underlying structural exposure created by these Funds.
In contrast, and central to the appropriate use of Mortgage Funds, many investors seeking regular income do so with capital over which they have a medium or long term investment perspective. This component of their capital does not require "at call" liquidity. Mortgage Funds are a fundamentally appropriate investment for medium and long term capital seeking regular income, without requiring expensive liquidity structures. Investors simply need to be aware of the term of the investment and allocate appropriate capital. This is the traditional source of Mortgage Fund capital.
In significant contrast to the redemption structure outlined above, appropriately structured Mortgage Funds thus far remain unimpeached in terms of liquidity after two years of global financial market turmoil, and are likely to remain so. Unfortunately Mortgage Funds retaining structural integrity are very much in the minority and certainly they have not been the focal point of media attention. The results however are starkly clear for all to see.
An example of a Mortgage Fund that has not modified its redemption structure is Money Magazine's 2010 Best Mortgage Fund, La Trobe Australian Mortgage Fund. Not coincidentally, La Trobe's Fund has not frozen redemptions in any way since inception and offers the highest rate of return over all time periods (a five year return of 7.72%p.a.)(1).
La Trobe's longstanding 12 month investment term (with access to partial interim redemptions
during the 12 months) very dramatically increases reliability of redemption entitlements (liquidity) and lifts investor returns. It allows investors of medium term funding to actually receive the full return premium for the true investment term, rather than this being lost through expenses associated with providing flawed short term liquidity structures (that these investors do not need). Our investors readily understand the structure and clearly rely on it with confidence.
Some discussion points arising from this are:
- Mortgage Funds should seek only appropriate investor capital for investment: La Trobe's rule is simple, 'invest the money you won't need for the next year'. This ensures a structure clearly in the best interests of investors, rather than growth of a manager's funds under management.
- Platforms are excellent for distributing certain products but to date have failed to address distribution of term products (other than platform owners' term deposits) such as Mortgage Funds.
- Mortgage Funds should be distributed on platforms but only as medium term investments. Otherwise
they should be offered outside platform framework.
- The real question is not whether properly structured Mortgage Funds continue to address end investor interests, they have for decades, but whether Mortgage Funds can meet the interests of those now controlling distribution in the retail investment industry.
- Of significant concern to La Trobe is that the industry's ongoing inaction risks creating a perception that the asset class itself is flawed, which is clearly incorrect. We believe that the problem is a product structuring issue of the industry's own making and that a clear alternate exists.
Mortgage Funds are an appropriate and important investment vehicle for people looking for reliable monthly income at a level above the bank bill rate and with stable capital value, but they are not cash management accounts and should not be portrayed as such or marketed as if they are.
If investors and advisers are aware of these issues, we believe very sensible decisions to invest medium term capital into the best performing, conservative Mortgage Funds will be a reliable and rewarding experience for investors.
The Mortgage Fund industry is now enduring a hard and well earned lesson about appropriate product structure and funding sources. A natural consequence of the above analysis is that the industry should reduce for a period, as short term capital withdraws. But if Mortgage Funds go beyond this to decline long term, the real reason is likely to reside with constraints dictated by distribution industry interests rather than any real question about the suitability of appropriately structured Mortgage Funds for the end retail investors.
We believe that the industry should show leadership on defining successful Mortgage Fund models in order to prevent significant damage to an investment class that has proven its performance over many decades.
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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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