What makes mortgage funds hot

Mortgage funds, although lacking the slightest hint of sex appeal, are the hottest asset class in the managed fund sector at the moment.

It's no surprise that investors are seeking safety in the income asset classes considering the state of international share markets that are headed into their third year of negative returns.

To illustrate the popularity of mortgage funds one has only to look at the latest funds flow figures from managed fund research house FundSource.

In the three-month period ending June 30, there was a net outflow of $83.52 million from managed funds across the board. However, in stark contrast to this overall result $154.7 million was invested in mortgage funds (that means a whole lot more money went out of other sectors).

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

In the next tier Equitable, ING and Perpetual Trust all recorded positive funds flow into their mortgage funds of between $5 million and $8 million each in the three month period.

The other interesting trend is that in recent months three new mortgage funds have arrived on the scene. First up was Wellington-based Lombard. It has been followed by SBS and now Property Pack.

Lombard's reason for launching its fund is different to the other two. The company had been an active player in the contributory mortgage market and decided that area had too many risks, so it is now in the process of switching its products into a mortgage fund.

With the mortgage funds growing in popularity and an increasing array of funds being made available the question becomes how do you choose a good fund?

FundSource analyst Rodney Harris believes one of the biggest issues to consider with mortgage funds is the management expense ratio (MER). In his view there is a close correlation between the MER and a fund's performance. (The lower the MER, the better the performance).

This is partly due to the fact that mortgage funds sit between cash and fixed interest on the risk/return graph, and in many respects they act as a slightly souped up cash fund. Harris says mortgage funds generally provide returns of between 100 and 150 basis points more than cash funds.

FundSource's research says that MERs range from anywhere between 0.75% and 1.5%. Some of the funds at the lower end are ASB Bank and Perpetual Trust, while Sovereign is at the higher end.

Another of the other big issues investors and advisers should look at is liquidity.

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

It's worth looking at where a manager sources its business, Harris says.

If the business isn't being written fast enough then the investors are getting little more than cash returns. Also there is an issue that mortgages could be written too quickly and some lower quality business goes on the book which in the end may default and reduce long-term returns.

Liquidity has been an issue with a number of funds before where inflows and writing mortgages get out of balance.

"Liquidity can have a reasonable impact on performance if liquidity gets too high," he says.

Harris says the liquidity within a fund can "shift quite dramatically", however it is presently noticeable that some funds have got close to their maximum cash holding limit which in some cases can be as high as 30%.

Other issues to consider when selecting mortgage funds include asking where the money is lent. Is it going into owner-occupied homes, investment properties, commercial or rural loans? Is the make-up of the fund's portfolio shifting much as its lending increases?

Harris says some funds are moving into new sectors that may have an impact on overall returns.

Also it is worth finding out about a manager's credit policy and how well they check out properties before writing mortgages, and what is the maximum percentage of a property's value will they lend up to.