The Five Ways Smart Investors Sidestep the Biggest Mortgage Fund Risks

When investors think about consistent income and risk management, mortgage funds are usually not front of mind. After all, their association with residential mortgage-backed securities can deter investors who remain cautious following the US subprime crisis that triggered the GFC. Those investors should bear in mind that Australia’s far more tightly regulated market offers protection against many of the same issues.

Australian investors may also have concerns about investing in a part of the market that could be impacted by defaults in a rising rate environment.

Situated within the private credit space, mortgage funds involve complexity and nuance, yet they can offer a range of benefits to investors.

Like any investment, they carry risks, and understanding these risks, along with the ways to manage them, can determine whether they are suitable for your portfolio.

In this article, I will outline how mortgage funds typically work and explore the risks and benefits of including them in your portfolio.

Types of Mortgage Funds

You may be familiar with the concept of a mortgage, where you take out a loan to purchase a property and repay it in instalments, paying fees and interest along the way.

In a mortgage fund, investors benefit from these mortgage repayments, including interest. In Australia, these funds are typically structured in two ways.

1. Pooled mortgage funds

In a pooled mortgage fund, your money is combined with that of other investors and spread across a range of mortgage loans. A fund manager selects the mortgages and oversees the fund’s operations.

Pooled funds may lend directly to borrowers or invest in mortgage-backed securities (MBS), which are a type of bond secured by a pool of property loans. These investments tend to be more liquid, allowing investors to withdraw funds when needed.

Examples include: Qualitas Real Estate Income Fund (ASX: QRI), Trilogy Monthly Income Trust and PMAC Trust – Pooled Mortgage Fund.

2. Direct or contributory mortgage funds

In a contributory mortgage fund, you invest in a specific mortgage that has been pre-identified by a fund manager. The fund remains open until sufficient capital is raised to fund the loan.

Your investment is typically ‘locked up’ until the loan is repaid, and minimum investment amounts are often higher. These investments may be more suited to institutional or wholesale investors and can carry a higher level of risk.

Examples include: GPS Invest Select Fund, HoldenCAPITAL Partners and 268 Direct Mortgage Fund.

Why Investors Use Mortgage Funds

Investors who allocate to mortgage funds typically seek the following benefits:

1. Regular income

Income is generated through the regular repayment of principal and interest by borrowers.

2. Potential for higher returns

Compared with traditional fixed income, such as government bonds, mortgage rates are typically higher to compensate for increased risk.

3. Property market exposure

Investors gain exposure to the property market without needing to directly invest in or manage property themselves.

4. Diversification

Mortgage funds are a form of private credit and often behave differently from listed markets.

5. Risk management

Mortgages are secured against an underlying asset, namely property, which can be used in the event of borrower default.

The Key Risks of Investing in Mortgage Funds and How to Manage Them

All investments carry risks. The following are some that are particularly relevant to mortgage funds, along with ways to mitigate them.

Risk 1: Capital Risk

Mortgage funds are not capital guaranteed. This means the amount you invest is not protected from loss. Investors considering mortgage funds as a bond proxy should remember that government bonds typically guarantee the return of principal.

How to manage this risk

To reduce the risk of loss, assess the quality of the underlying loans, the expertise and track record of the fund manager, and the loan-to-value ratio (LVR).

A conservative LVR, for example below 60 per cent, reduces the likelihood of loss. In a default scenario, the value of the property is more likely to exceed the loan amount.

During the US subprime crisis, loans were often issued at values exceeding the underlying property, a practice that Australian regulation helps prevent.

Some fund managers prioritise ‘first mortgages’, which are the primary loans secured against a property. By contrast, second or third mortgages are taken against equity and typically carry higher risk. First mortgages have repayment priority in a default scenario and are therefore considered more secure.

The fund manager’s expertise and track record are also critical in identifying and managing suitable loans.

Risk 2: Interest Rate Risk

Many mortgages have variable interest rates, meaning returns may fluctuate with changes in interest rates. Falling rates can reduce income, while rising rates may increase income but also place pressure on borrowers’ ability to repay, increasing default risk.

How to manage this risk

Some funds use shorter-term loans or employ interest rate hedging strategies to stabilise income.

Borrower quality and conservative LVRs remain essential, particularly in rising rate environments.

Risk 3: Market Risk

Property values can fluctuate, even in a market like Australia where long-term growth has been strong. The Australian Property Institute reported that capital city housing prices increased by 154 per cent over the 20 years to June 2024, compared with a 67 per cent increase in inflation.

However, prices can still decline, which affects loan values and repayment capacity.

How to manage this risk

Diversification is key. Loans should be spread across different regions and property types.

For example, concentration in a single town reliant on one industry, such as mining, increases risk.

Different property sectors can also be cyclical. Office property, for instance, fell out of favour after the COVID pandemic due to remote working, though conditions have since improved.

Conservative property valuations and strong borrower quality also help mitigate this risk.

Risk 4: Default Risk

Default risk is the possibility that a borrower cannot repay their loan. This can result from personal circumstances or broader economic factors such as interest rates and inflation.

How to manage this risk

The primary defence is borrower quality and conservative LVRs. Borrowers with strong employment histories and credit profiles are better positioned to withstand economic stress.

In worst-case scenarios, a low LVR allows the property to be sold to recover the loan.

Using first mortgages also improves recovery outcomes in default situations.

Equally important is the fund manager’s ability to work constructively with borrowers. In some cases, restructuring or support measures can avoid unnecessary defaults and preserve long-term repayments.

Risk 5: Liquidity Risk

Liquidity risk arises when a fund cannot meet withdrawal requests due to insufficient available cash.

Withdrawals are generally available in pooled funds but are typically not permitted in direct or contributory funds, where capital is locked in until the loan is repaid.

How to manage this risk

Some fund managers maintain cash reserves or impose withdrawal restrictions to manage liquidity.

There is also an institutional market for mortgage-backed securities, which may allow managers to sell underlying assets if necessary, although this can take time.

Investors should consider their overall portfolio liquidity and ensure they have sufficient accessible funds elsewhere.

If liquidity is important, it may be worth selecting funds with cash buffers or flexible withdrawal arrangements, or reconsidering whether the investment is appropriate.

Using Mortgage Funds and Balancing the Risks

Across these risks, five key principles can help investors manage exposure more effectively: lending to high-quality borrowers, focusing on first mortgages, maintaining conservative LVRs, diversifying across property types and regions, and selecting experienced fund managers.

While capital preservation is not guaranteed, applying these principles can significantly improve risk management.

As always, investors should take the time to understand how mortgage funds operate and how they fit within their broader portfolio to ensure they align with their objectives, risk tolerance, and liquidity needs.

Funds Mentioned

Disclaimer: This article is prepared by Sara Allen. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.