Safe as houses

By MARK FRYER

You could say that mortgage funds are safe. You could also say they're a little dull - and that's just fine with investors.

As money continues to pour out of managed funds which invest in shares, a lot of it is turning up in funds which put their money into mortgages.

In the first three months of this year alone, mortgage funds attracted another $130 million, according to figures from industry researcher FundSource.

Investors now have $2.8 billion in the 11 mortgage funds surveyed by FundSource, some of which have grown very large indeed - Westpac's Home Loan Trust had $729 million at the end of March, the ASB Residential Mortgage Trust $672 million and the BNZ Mortgage Distribution Fund $365 million.

The reasons for the influx can be summed up in one word: security. Mortgage funds may not offer the chance to make a quick killing like sharemarket funds, but nor are investors likely to wake up one day wondering where their money went.

The growth of mortgage funds over the past three years or so parallels the fall in international sharemarkets which has been so painful for so many investors. Rising interest in mortgage funds isn't just a New Zealand story; the same thing has happened in Australia, too.

The idea behind a mortgage fund is simplicity itself: the fund manager gathers in a lot of money from investors, lends it out to property buyers, who make interest and principal payments, which are then passed on to the investors. Along the way the manager makes a profit by deducting fees.

They're never likely to be spectacular performers, but investing in mortgages promises high security, and right now that's more important to many investors than the elusive prospect of a high return.

According to their managers, mortgage funds aim to provide returns that are "competitive with an equivalent term deposit" (Westpac): "superior ... to short-term bank deposit rates" (Axa); or provide "capital stability and steady growth of your savings" (BNZ).

It's a modest goal, but how have the funds performed?

Over the past year, after-tax returns have ranged from 3.26 per cent to 4.56 per cent, again according to FundSource figures. Over the past three years, the best-performing mortgage fund produced 4.36 per cent a year, the worst 3.57 per cent.

Those returns are after deducting any ongoing fees (but not any initial fees) and after deducting tax at 33 per cent.

For a taxpayer in the 33 per cent bracket, the one-year returns are the equivalent of earning 4.86 to 6.8 per cent, before tax.

How does that compare with the obvious alternative, putting your money into bank term deposits?

A year ago, at the end of March 2002, you could have picked up a one-year term deposit from one of the major banks paying 5.5 per cent, before tax. The best-performing mortgage funds have indeed done better than that, by as much as 1.3 percentage points.

But the longer term numbers suggest that beating the bank isn't easy. An investor who put $10,000 into the best-performing mortgage trust on FundSource's list three years ago would now have about $11,366, after tax at 33 per cent. But if he or she had simply looked for a one-year term deposit at the beginning of each year, sticking to the major banks for security, that $10,000 would have turned into $11,327, again after tax at 33 per cent. Again, the best funds win, but only by a slender margin. And if the investor had chosen the mortgage fund that turned out to be the worst performer, he or she would now be well behind the term depositor.

But the big issue for most mortgage trust investors is more likely to be security. While mortgage funds aren't entirely immune from things going wrong, they're at the lower-risk end of the scale.

The obvious danger is that some of the people the fund lends money to may default on their loan payments. But fund investors can take comfort from the fact that their money is spread across many mortgages, rather than relying on just one borrower.

Another risk comes from the fact that, as well as mortgages, some funds put investors' money into other things, such as government stock. That raises the danger that, if interest rates move sharply, some of those investments could lose value.

Some mortgage trust investment statements also warn that managers can suspend withdrawals in some circumstances - for example, if many investors want to withdraw at the same time.

There's a more obvious risk; future returns from mortgage funds will depend on what happens to interest rates, especially short-term rates.

While predicting interest rates is only marginally more precise than picking racehorses, in the short term at least they appear more likely to fall than rise, meaning mortgage fund returns will follow suit.

* To contact Personal Finance Editor Mark Fryer write to: Weekend Herald, PO Box 32, Auckland. Email: mark_fryer@nzherald.co.nz. Ph: (09) 373-6400, ext 8833. Fax: (09) 373-6423.