When it's hot to be uncool

By PHILIP MACALISTER

Mortgage funds are a bit like Peter Dunne's United Future party - unsexy, middle of the road and common sense.

But while appearing sensible and straightforward from the outside, both United Future and mortgage trusts get a bit more complex when you lift the hood and examine how they work.

More on that later. The other factor which ties them together is that both are "hot" at the moment, and for much the same reason.

When there is turmoil and more extreme views all around (ugly sharemarkets and Green politics), people turn to what they see as sensible and non-threatening options - United Future in politics and mortgage trusts for investment.

The popularity of mortgage trusts is illustrated by the latest figures from managed fund research houses FundSource and Morningstar. Their numbers show that while more than $80 million flowed out of managed funds in the three months to June 30, there was a strong inflow into mortgage funds.

FundSource says $154.7 million was invested in mortgage-backed funds during the quarter while, in total, $83.52 million was taken out of the whole managed fund industry (that means some other sectors like international shares and balanced funds lost lots of money).

As has been the trend for several years, the banks are dominating this sector, with ASB attracting $68.1 million in the quarter and WestpacTrust and BNZ pulling in $53.2 million and $29.2 million respectively.

Mortgage trusts have been popular for several years. This is due to many factors, including their "safe haven" status and the fact that they are tied into New Zealanders' best-loved investment option, property.

With mortgage trusts, investors' money is pooled, then lent to property buyers.

Because they are backed by the security of a property and a mortgage, these sorts of trusts are quite secure.

Mortgage trusts occupy a space at the low-risk, low-return end of the investment spectrum, jostling for position with cash, term deposits and contributory mortgages.

The idea of mortgage funds being low-risk may surprise anyone with experience of another form of mortgage-backed investment - contributory mortgages.

Both mortgage trusts and contributory mortgages are a way of investing in other people's property loans, but the biggest difference is in the way they are structured and who they lend to.

People who invest in contributory mortgages tend to become lenders of last resort to property developments. Because these ventures are much more likely to fail, the borrowers pay relatively high interest rates. That puts contributory mortgages into a higher-risk bracket than, say, a bank mortgage fund which is providing funds for residential mortgages.

But to cloud the picture a little further, not all contributory mortgages are in the higher-risk property area.

Mortgage banker Cairns Lockie says the problem with contributory mortgages is that some people use them incorrectly.

"They shouldn't be used for speculative subdivisions or development [properties]," says director William Cairns.

He argues that contributory mortgages should fund residential properties, small farm loans and commercial buildings.

The other twist is that two firms which were big promoters of contributory mortgages have switched to mortgage trusts.

The most high profile of these is Money Managers, which now puts most of the deals it would have previously sold to the public as contributory mortgages into its First Step mortgage funds.

The second is Wellington-based investment banker Lombard, which is in the process of switching all its contributory mortgage business into a mortgage fund.

Lombard chief executive Michael Reeves says the move was made because of regulatory concerns and the perception that contributory mortgages did not have tight enough rules.

One of his concerns was that contributory mortgages did not have an independent trustee like many other sorts of investments.

Reeves felt there were flaws in the current structure and did not like Lombard being "tarred with the brush that's being wielded about".

This switch illustrates one of the underlying benefits of managed funds, where a series of investments are pooled to lower the risk.

Money Managers managing director Doug Somers-Edgar says if it was using the First Step mortgage trust approach several years ago the firm would have avoided some of the high-profile problems it has had with its property investments.

"If any of those three - Ballantyne, Park Terraces and Metropolis - had been done by First Step there would have been no loss to investors. We would have stepped in early and solved the problem."

He uses the troubled Ballantyne property bond issue in Katikati as an example. This golf course and housing development got into trouble when sales didn't proceed at the rate expected, leaving the developer short of money to finish the project.

Somers-Edgar says if it was in the First Step structure the fund could have provided the necessary extra funding, investors would not have lost money and the development would have been completed.

"FirstStep would have advanced the money and [the problem] would not have happened. It only needed $1.5 million."

Lombard and Money Managers are not the only two relatively new players in the mortgage trust sector. In recent months, SBS and Property Pack have also entered the market.

Both have aspirations to play in the managed fund market and the mortgage trust area is a natural starting place because they are both active in the mortgage-writing business.

With all these products out there, how do you pick a good mortgage fund?

From the exterior they all look the same, but once inside there are many differences, such as who the trust will lend to, what sectors (rural, residential, development etc) the fund writes loans in and how well it assesses proposals.

FundSource analyst Rodney Harris says a key number to look at when considering a mortgage trust is its management expense ratio (MER), the percentage of money gobbled up in running the trust.

The lower the MER, the better the performance.

FundSource research says MERs range from 0.75 per cent to 1.5 per cent. Funds at the lower end include ASB Bank and Perpetual Trust, while Sovereign is at the higher end.

With a surge of money into mortgage funds, the managers have to find appropriate mortgages to write.

Harris says it is worth looking at where a manager obtains business.

If the business is not being written fast enough then investors are getting little more than cash returns. There is also the danger that mortgages could be written without the usual credit checks.

The other issue investors need to be aware of is how tax affects returns.

A mortgage trust should provide returns of between 1 per cent and 1.5 per cent above short-term bank deposits.

However, those higher returns may not be apparent to investors after they have put their money into a mortgage fund.

The reason is all to do with tax. Because a unit trust is taxed at 33 per cent, investors on a lower rate may be paying too much tax.

Things are not quite as bad as they seem, because people on these lower tax rates get imputation credits, which they can use to reduce tax on any other income.

However, this system is administratively cumbersome for investors, many of whom don't file returns.

The Bank of New Zealand offered a solution to this problem this year when it launched a new fund in addition to its existing mortgage unit trust. The new Mortgage Distribution Fund uses a different structure in which investors are taxed at their personal effective tax rate, not the flat 33 per cent a unit trust must pay.

BNZ says the new fund's structure makes it "ideal for those on a rate of 19.5%".

Judging from mortgage funds' track record they will remain popular with investors. Whether punters remain as faithful to United Future has yet to be seen.

* Philip Macalister is the editor of Asset magazine and online money management magazine Good Returns. His email is philip@goodreturns.co.nz