While no investment is entirely without risk, investors can minimize their exposure to unwelcome surprises by understanding common investment risks and how to guard against them. Risk is defined as uncertainty regarding the future performance of an investment that may potentially result in losses. A basic concept related to investment risk is the trade-off between risk and return; in the long run, riskier investments must generate higher returns to compensate investors for taking on added risk. For example, long-term stock returns adjusted for inflation have averaged 7% annually, although investors who lived through the 2008 market crash know that stocks can be risky. Conversely, a nearly risk-free investment (3-month treasury bills) yielded less than 1.0% annually over the same period.
Investment risk can’t be eliminated entirely, but there are simple strategies that can help manage systematic risk (linked to the broad economy), and unsystematic risk (associated with a particular asset class). The first is asset allocation, which means holding a variety of different assets. The second strategy is diversification, or owning a variety of holdings in each asset class. For example, a diversified stock portfolio typically consists of 10 or more stocks spread across different sectors of the economy (i.e. consumer, healthcare, technology, etc.).
Owning mortgage pool funds can bring diversification as well as high risk-adjusted returns to a portfolio. This is because mortgage pool funds combine the reliability of a fixed income product with the diversification benefits of real estate, which helps insulate investors from these five common risks:
Due to a low correlation with stocks and bonds, mortgage pool funds may help reduce portfolio volatility. These funds provide real estate exposure and real estate has been shown to have a very low correlation with stocks. In 14 of the last 15 stock market corrections, real estate prices rose when stock market prices dropped, according to this Barron’s story. The benefits of owning real estate are also demonstrated by the NCREIF property index, which has produced 8.8% annual returns over the last 15 years, far exceeding the 6-7% annual returns of the S&P 500 over the same period.
In addition, diversification within the mortgage pool fund portfolio mitigates unsystematic risk. The pool’s loans are varied by maturity date, geography and property type. As a result, mortgage pool funds are much less volatile than direct property ownership or crowd funding deals, which typically invest in only a few properties.
As an asset class, real estate has also proven itself to be an effective hedge against inflation. A TIAA-CREF study showed that, real estate returns move in concert with inflation over the short-term and outpace inflation over the long-term. According to TIAA-CREF, real estate outperformed inflation 83% of the time and produced an excess return over the inflation rate averaging 7%. Real estate’s correlation with inflation is much higher than the stock market’s correlation with inflation, which is why stocks are considered a weak short-term inflation hedge. Bonds are even worse, with returns typically declining as inflation rises.
Real estate’s usefulness as a hedge against inflation is due to the way property leases are structured. Short-term leases allow frequent rent increases and long-term leases usually contain rent escalation clauses tied to annual inflation. In addition, property values keep pace with inflation since rising rents equate to increased property cash flows, which enhances real estate values.
3) Interest Rates
Compared to other fixed income assets, mortgage pool funds are far less sensitive to interest rates changes. This is a result of their short terms to maturity. A typical mortgage pool loan matures in one to three years. Short maturities mean that loan value doesn’t change appreciably when interest rates rise since capital from maturing loans is quickly rolled back into new loans bearing higher interest rates.
Another factor shielding mortgage pool funds from rising interest rates is a strengthening economy. Higher rates usually signal economic expansion. Robust economic growth benefits mortgage pool funds by creating new lending opportunities that fuel asset growth.
One of the biggest risk factors associated with real estate investing is poor liquidity. Properties can take months or even years to sell and cash-strapped investors may be forced to sell at a loss. Most mortgage pool funds address the liquidity issue by allowing investors to withdraw capital from the fund with reasonable advanced notice (i.e. usually one quarter). However, fund start-ups may sometimes have lockout provisions that preclude investor withdrawals in the fund’s early years so investors should read the offering documents and carefully consider the amount of money they are willing to commit to a long-term investment.
5) Lack of Transparency
Mortgage pool funds must comply with the rules of various state and federal government agencies, which are described in their disclosure documents. The principal document is the offering memorandum, which contains information regarding the fund’s structure and objectives, management team experience and the fund’s historic operating performance. Disclosure requirements for mortgage pool funds are much more rigorous than those of crowd funding deals, which may offer little information about a project’s management team or the track record of the project developer.
In addition, subscribers to mortgage pool funds often have greater access to the fund’s senior management than do public company shareholders or bondholders. This is the result of how funds are structured. Most mortgage pool funds have fewer than 100 subscribers, making it easier for fund executives to respond to individual investor inquiries.
Mortgage pool funds can be a great vehicle for capturing the diversification benefits of real estate without the drawbacks of direct property ownership. An added benefit is that many funds pay dividends monthly, thus providing reliable income, Subscribers can also increase their fund holdings through automatic reinvesting. Fund liquidity concerns are addressed by making shares redeemable on reasonable notice. Most mortgage pool funds are also IRA and/or rollover qualified, making them suitable holdings for retirement accounts.