Why mortgage funds face the biggest investment risks

Mortgage fund managers face the highest investment risk. Photo / 123RF

Mortgage fund managers face the highest investment risk across the managed fund sector and even taking steps to reduce risk means they remain at a medium level, a new report by the financial market regulator has found.

The Financial Markets Authority surveyed the four supervisors who oversee New Zealand’s fund management industry including the KiwiSaver providers and asked the supervisors to rate the risk level of each manager across 22 factors and how effective mitigants were used to manage those risks.

The research found if no mitigations were in place the overall risk of the sector would be medium to high but including the mitigation steps the sector was rated medium to low with the likelihood of harm occurring considered to be minor.

But it also found pockets of higher risk within the sector. It broke the fund managers down into large, medium and small players and mortgage funds and found that even after mitigation the risks were higher for small managers (those with funds under management of under $250 million) and managers of mortgage funds.

Paul Gregory, FMA director of investment management, said risk was part of running a managed fund.

“Risk is not bad for a managed fund, risk is what produces returns so risk is necessary but it still has to be well-managed.”

But he said any fund which invested in a single asset class, like mortgages, was riskier.

“A mortgage fund is concentrated, all of it will go up and down depending on what affects that type of asset, in this case a mortgage and so there is interest rates, the ability to pay back the mortgage, all of that stuff is consequent on the economy at the time.”

Gregory said there was also the operational side with the mortgages. “Which is how to source them, how to manage them, you need to have some property knowledge as well as investment knowledge with these sorts of things.”

Lack of liquidity was seen as the top contributor of investment risk for mortgage funds, followed by macro impacts on investments such as interest rate volatility which was being seen at the moment and fund concentration.

The report also noted mortgage funds had limited staff, senior management and board resources due to their smaller size relative to other fund managers.

“Mortgage funds often have significant transactions with their related business partners. Although no mortgage fund manager has been found to have breached the conflict-of-interest rules, this still contributes to governance risk.”

Smaller fund managers were also found to have a higher risk than the sector overall due to having higher than average governance risk.

Smaller managers tended to have weaker financial strength than larger managers due to a lack of fund scale, lower levels of capitalisation, cashflows and revenue streams.

The report noted they may also lack independent directors, have a board dominated by some members, stretched board capacity and insufficient reporting processes due to their small size, limited staff and professional resources.

Some smaller fund managers also had a lack of established investment processes and capacity.

Paul Gregory, the Financial Markets Authority director of investment management. Photo / Supplied

Gregory said the report would help it focus its attention.

“We could look anywhere but we don’t have the resources to look everywhere so we have got to choose where we focus our attention and that’s what this piece of work is all about.

“This is a heat map of where our attention is best focused.”

The report also looked more closely at specific risk areas and identified product offering risk as one of the most significant risk factors and one that required closer monitoring. That risk included product management, offer documentation, product and risk disclosure, distribution and advertising.

It survey found there were often errors in offer and disclosure documents such as errors in calculating fund returns. While another main risk was that advertising and marketing used unsubstantiated assumptions which could mislead investors.

However fund managers with good governance had taken steps to mitigate those risks.

It noted some fund managers were seeking to improve their competitiveness by introducing novel or high-risk financial products into their offerings. Some fund managers have invested in cryptocurrency, private equity, commodities and venture capital in recent years.

Gregory said when it came to investing in private equity or unlisted assets there was a place for that in long-term investment portfolios.

“But that risk needs to be managed well.”

Crypto risk

But when it came to investing in cryptocurrency Gregory pointed to the short track record of the asset class.

“It has only been in existence for 12, 13 years and so when we talk to investment managers about including crypto, particularly in KiwiSaver, and not in KiwiSaver, what is the investment logic for putting this in your portfolio in the first place? What role is it serving for you and your members?

“It has simply not been around long enough for it to have enough of a return track record for a manager to say credibly well it’s like equities or it’s not like equities.”

Gregory said any manager that included it in its investment offering needed to be very clear to investors why it was in the portfolio as well as clear warnings about its volatility.

“There is a very high risk there will be losses or at least quite big fluctuations in the value of your overall fund and you don’t need to have too much crypto in a fund for it to have quite a big effect on the whole fund either.”