Diversification and the Role of MICs
Every investor knows that diversification is necessary for financial success. By investing in multiple types of investments, you can balance risk and return, increase stability, and avoid extreme ups and downs. Trying to time the market and find the best usually results in losses and high levels of stress.
Today, however, a standard 60/40 diversified portfolio of stocks and bonds may not be enough to generate desired returns. According to Bank of America, 60/40 portfolios are facing their worst returns in 100 years. Also, depending on how it’s calculated, Canada’s inflation rate is between 7% and 15%, and your investment needs to generate at least that amount to get a positive return and maintain the purchasing power of your savings. As a result, many investors today view alternative investments as a key component of a well-diversified portfolio.
Mortgages are one of the fastest-growing areas of alternative investing, offering investors stable cash flow, risk-free real estate exposure of homeownership, and broad diversification beyond just equities and bonds. Mortgage investing also fulfills one of the core aspects of diversification. With low correlation to public markets, Mortgage Investment Corporations (MICs) provide one of the easiest ways to gain direct exposure to Canada’s mortgage market and are a strong asset within the country’s historically strong real estate sector.
What Is Diversification?
Diversification is the last and best string of many fund managers, financial planners, and individual investors. It is a management strategy that mixes various investments in a single portfolio. The idea behind diversification is that different investments will yield higher returns. It also suggests that investors face less risk when investing in various vehicles.
Diversification of MIC
MICs are diversified in several ways. Unlike traditional portfolios composed of stocks and bonds, individual MICs diversify based on a range of unique criteria.
Geographical Situation
MICs seek to diversify their holdings by investing in a wide range of geographies. Some focus on a single region or province, while others invest nationwide. MICs may also diversify by investing in suburban, urban, or rural areas, or in traditionally strong centers such as Vancouver and Toronto.
Type of Investment
Canadian income tax law requires MICs to invest at least 50% of their assets in mortgages, while the remainder may be invested in commercial or residential properties.
Loan-to-Value (LTV)
The loan-to-value ratio compares the value of the property to the amount of the mortgage. For example, if the property is $500,000 and the mortgage is $400,000, the LTV ratio is 80%. Generally speaking, the higher the LTV, the higher the risk for the lender, but also the higher the interest rate for the borrower—resulting in higher potential returns. MICs aim to balance risk and reward to produce consistent returns.
Management Style
MICs can have very different management styles. Some borrowers may prefer high-risk, high-yield loans, while others operate with a more balanced approach. A MIC may be managed by an individual or a team of experienced investment professionals overseeing the entire portfolio.
Shareholders
Each MIC must have at least 20 shareholders, and none can own more than 25% of the outstanding shares. This minimizes concentration risk and helps protect the investment if a borrower defaults.
Length of Mortgage
Personal mortgage terms generally range from 6 to 36 months, with 12 months being the most common.
Borrower
All borrowers are subject to rigorous screening. Factors such as creditworthiness, income, and debt level are considered before a mortgage is issued. This process reduces the risk of default for investors.
Type of Mortgage
MICs can invest in 1st, 2nd, or 3rd mortgages. The first mortgage is the primary loan on a property. Second and third mortgages are subordinate to the first and will be repaid only after the first is settled in the event of default. These are all backed by underlying real estate assets.
Indirect Access to the Market
MICs offer a way to participate in the Canadian real estate lending market without becoming a direct lender. Investors generate passive income by owning shares in the MIC. The MIC’s management team oversees daily operations and provides detailed reports to keep investors informed. Loans are carefully selected under strict investment guidelines to maintain quality.
When the market is booming, it may seem almost impossible to lose money. However, market fluctuations are inevitable, and a well-diversified portfolio is essential in all conditions. MIC funds have historically delivered returns of 6% to 11%, making them a compelling alternative investment—especially compared to the average 2.0% return on the Canadian 10-year bond.