Re: Octaviar MFS Premium Income Fund PIF
Hi Seamisty
I seem to recall that before City Pacific made an offer for MFS, that MFS actually performed due diligence on City Pacific with the view that MFS would acquire City Pacific sometime in 2007.
In trying to find the evidence for that, I came across this article from SMH on 28Apr07 titled "Homework tips to help avaid another Fincorp".
I have included an extract, which includes quotes from Grant Harris, the MFS PIF Fund Manager at the time --- makes for some interesting reading, given the date, and his comments.
But mortgage funds or diversified high-yield income funds are not like equity investments, where the price of an underlying security moves up and down every day on a stock market. Instead, the funds will often quote a "target rate" of return.
Assessing the risk of a fund that offers a target rate of return is a tricky proposition. How do you rate the risk of a fund that has, for example, a target rate of 8.5 per cent a year, and has achieved this rate of return every year for the past five years?
There's no volatility - the traditional measurement of risk - in the target rate. And, unlike a fund that invests in equities, where an announcement by a company to the stock market can trigger a sudden price movement (up or down), investors in a mortgage fund or diversified high-yield fund often don't know about risk until an event has occurred - and by then it can be too late. Just ask investors in the failed Fincorp group.
If those investors had been guided solely by the ability of Fincorp to pay distributions, few investors would have recognised that there was any risk at all.
The target rate of return that Fincorp offered did not fluctuate from day to day, or even from month to month, in line with the financial health of the company.
Investors' views of Fincorp may have been quite different if the returns they received moved up and down regularly, or if the returns had reflected the financial well-being of the company itself.
There is the investment adage that the higher the return you get from an investment, the greater the risk must be.
But for reasons attributable to human nature, this warning often goes unheeded.
Besides, as the Herald reported recently, it can be difficult to recognise a "high" return in the first place - whether a particular return is high depends, among other things, on what underlying assets you're investing in, the risks associated with those assets, and how long you plan to invest for.
Even so, every investment involves risk. The potential trap in fixed-term products that offer some "certainty" of return, such as a target rate paid monthly, is that investors see the funds as low-risk. Or, at least, they fail to recognise the risk inherent in the product. They see a steady, stable rate of return and conclude (either consciously or subconsciously) that, because there's no volatility, there's no risk.
But the target rate of return quoted by the fund must be generated somehow and, if the target rate is greater than the prevailing cash rate (at the moment, that's 6.5 per cent a year), the investment simply must involve higher risk than investing in cash.
The risks of fixed-interest and mortgage portfolios are monitored closely by advisers and researchers. In early April the research firm Lonsec downgraded its recommendation on the LM Mortgage Income Fund from "fund watch" to "redeem".
"Lonsec recommends advisers commence action to withdraw client funds," the researcher said. "Where the fixed-term option is being used, Lonsec recommends that advisers withdraw client funds when those investments reach maturity.
"The primary reason for the recommendation downgrade to 'redeem' is the overall assessed risk/return profile of the fund."
Lonsec says the LM fund is one of only two funds it rates that offer a fixed return. "Whilst fixed returns are attractive to end clients in providing certainty, for large funds in the current environment, mortgage managers may face operational and market risk," it says.
"Funds adopting the fixed-return model are required to generate a portfolio return sufficient to pay the target return to all investors regardless of market conditions.
"As a result, managers in the mortgage fund sector employing this model are required to maintain a high investment level or charge favourable rates on funds lent to borrowers. In the current market it has been difficult to charge attractive rates to high-quality borrowers.
"Lonsec's research of mortgage fund managers and originators indicates that there is 'margin compression' in the lending market due to aggressive activity and the weight of money in the mortgage sector.
"Lonsec does note, however, that LM has a history of capital stability and meeting its advertised term return rates."
Lonsec says that where it "identifies high risk within a product/manager, it is appropriate that a suitable return is provided to investors for bearing that risk".
"In Lonsec's opinion, LM's return currently falls short of the return required to adequately compensate for the level of risk assumed relative to the risk-free rate and higher-yielding 'at-call' cash accounts.
"The risk profile of the product/manager is a function of internal factors specific to LM and external factors generic to all mortgage fund managers."
Investors, either on their own or with an adviser, have to identify what the risks are and then decide if the return they're likely to get from the investment justifies the risk.
Grant Harris, fund manager for MFS Investment Management's Premium Income Fund, says it can be like unscrambling an egg.
"For an investor attempting to measure the risk associated with a mortgage fund or an income fund, the challenge is to understand the investments in the fund's underlying portfolio, from which it's intended that the target rate of return will be earned, and to effectively pull it apart and assess what each component would earn in the market in its own right," Harris says.
He says Fincorp may serve as a textbook example of how to do this, and how different the investment picture might have looked if investors had done so. But it's a technique that investors can use for investment opportunities being promoted right now, because some still have the same structure as Fincorp.
"To understand the risks involved in an investment in Fincorp's income fund, investors needed to understand the underlying pool of investments in that fund from which Fincorp derived the returns that they then used to pay investors their return in the form of regular monthly distributions," Harris says.
"If an investor had read the fund's product disclosure statement [PDS] and the fund's annual report they would have learned that, at the time Fincorp announced it was in financial trouble, about 75 per cent of the fund's assets were 'related-party' loans.
"In other words, Fincorp was using the funds raised from investors to lend to its construction and development business, which in turn used the funds to secure vacant blocks of land for future development.
"In return for providing these funds, investors received an annual distribution of 8 per cent a year."
Investors could have gauged whether that was an adequate return for the risk only by comparing the underlying assets of Fincorp's fund with the assets of other funds that offer a similar return. Then they'd have to compare the risks and returns of each.
But in the case of Fincorp, Harris says, there was another warning sign. As well as its income fund, Fincorp offered a return of 9.75 per cent a year to investors who bought debentures issued by the company.
Given what we know about the relationship between risk and return, it would have been reasonable to conclude that the money raised from debentures was invested in a riskier pool of underlying assets.
But no.
"It turns out the funds were being used to finance exactly the same property developments as the 75 per cent of those funds invested in Fincorp's income fund, for which investors received a return of only 8 per cent," Harris says.
"Effectively, investors in the debentures and in the income fund were being exposed to similar underlying investment risks but receiving very different returns.
"This should raise alarm bells in investors' minds, and should make them wary of investing in structures like this in the first place."
Harris says investors need three pieces of information to compare one fund's assets with another fund's: first, how much related-party lending is going on; second, the size, number and purpose of the related-party loans; and third, the interest rates being charged on the loans.
Harris says this information should be disclosed in a PDS or annual report, or you could contact the manager's investor relations department. If they cannot or will not tell you, look for somewhere else to put your money.
Once you've got this information, you need to work out a few other things, such as what sort of construction and development the loans have been made on, whether the loans create a concentration of risk (is all the money lent for the same type of construction or development?), and whether the interest charged on the loans is similar to what the borrower would have to pay on the open market.
In this context, "related-party lending is problematic because it involves a situation where an investment fund owned by Parent Company A is lending to a construction and development company also owned by Parent Company A", Harris says.
"In other words, they are lending to themselves. Where this exists, investors who want to minimise their risk should assume that the interest being charged is below the market rate. Then it should be up to the fund manager to prove that it is not."
I'm sure that many will have comments!! Isn't hindsight a wonderful tool??