Since the fall of the markets in 2000, investors have moved in droves to safer investments like GICs, bonds and other fixed income investments. Quite often the topic of mortgage funds comes up as a safer investment alternative. Couple that with the corresponding rise in real estate prices across the country and you've got some increased demand for mortgage fund products. In Canada, there is about $6.5 billion dollars invested in mutual funds.
What are mortgage funds?
Canadian mortgage funds invest in commercial, industrial and/or residential mortgages and mortgage-backed securities. A mortgage-backed security is a unit of a fund that invests in insured home mortgages that pays interest and part of the principal.
Mortgage funds typically hold the majority of the portfolio in mortgage-backed securities, and a small amount in cash and Canadian bonds. In fact, here is the breakdown of the average mortgage fund as reported by Morningstar Paltrak.
- Cash 12.3%
- Canadian Bond 22.8%
- Mortgage Backed Securities 64.7%
- Other 0.2%
Mortgage funds are considered secure investments. However, the market values of mortgages can vary with changes in mortgage rates. Consequently, mortgage mutual fund values can also fluctuate. Mortgage funds are generally a lower-risk investment than equity and bond funds. Note however, that low risk investments are not the same as a “risk-free” investment.
Most mortgage funds are RRSP eligible and aim for safety of principal and regular income. Interest is paid either monthly, quarterly or annually. Mortgage funds usually have average terms to maturity of less than five years.
Mortgage fund performance
Mortgage interest rates are, in most cases, higher than interest rates on other debt securities such as bonds, guaranteed investment certificates and debentures with the same term to maturity. Consequently mortgage funds aim to provide a higher level of interest income. They are suitable for individuals who require interest income for current needs and for people seeking a conservative investment for retirement savings.
If you look at mortgage rates on www.moneysense.ca, you will see that the average 5-year mortgage is paying about 6.1%. That's significantly higher than the 5-year GIC rate of 4% to 4.6% (rates quoted as of Monday July 12, 2004).
However, the actual performance of mortgage funds has been quite lack luster. The average Canadian mortgage fund for 1 year was 2.25%. Over 3 years, mortgage funds averaged 4.29% and for 5 years the return was 4.57%. Over the past 10 years, mortgage funds returned 5.59% compound average annual returns.
Part of the discrepancy between posted mortgage rates and actual returns results from the Management Fees that are charged by mortgage funds. As a rule, mortgage funds are typically more expensive than money market investments and some bond funds in terms of management expense ratios (MERs).
The average MER for mortgage funds is a whopping 2.07%. That makes it pretty difficult to make money on these types of investments.
Two of the biggest mortgage funds in Canada are the Investors Group Mortgage Fund and the London Life Mortgage Fund with combined assets of $2.65 billion have MERs of 2.02% and 2.36% respectively. At the other end, the mortgage fund with the lowest MER is the HSBC Mortgage Fund with a MER of 1.53%.
Not all mortgage funds are created equal. As with any investment, analyze the fund's portfolio before you invest.
My two cents
Mortgage funds can be appropriate for part of a balanced portfolio because they can offset price volatility common to many other investments. They tend to be very safe investments with a very low chance of loss over 1 year. However, be aware of the fees of mortgage funds as they can be high and as a result have a significant impact on your net returns.