Unheard of a few years ago, ARM-backed funds seek high income, low volatility


December 01, 1991|By WERNER RENBERG | WERNER RENBERG,1991, Werner Renberg

Maybe you thought it wasn't possible to create any new varieties of mutual funds. After all, Lipper Analytical Services already has classified about 2,700 stock and bond mutual funds into nearly 50 investment categories.

But you would have underestimated the creativity of fund marketers and their desire to generate more income from share sales and money management.

Take adjustable-rate mortgage funds as an example. Lending institutions developed ARMs in the late 1970s for homebuyers whose hopes for lower interest rates made them reluctant to take out long-term mortgages at high fixed rates.

In the early 1980s, the Federal Home Loan Mortgage Corporation (Freddie Mac), Federal National Mortgage Association (Fannie Mae), and Government National Mortgage Association (Ginnie Mae) began to issue or guarantee ARM-backed securities to attract more capital into the housing industry.

Then, in 1987, the Franklin Group launched the first mutual fund to be primarily invested in pools of such securities. It was the predecessor of today's Franklin Adjustable U.S. Government Securities Fund.

Its SEC registration statement, declared effective on Oct. 5, 1987, gave its goals as high current income and lower volatility of principal. By the time Franklin was ready to offer shares to the public a couple of weeks later, the intervening stock market crash had given these goals added appeal.

Although the fund had the field to itself for three years, it gained little attention for the first two.

Last year, it took off. By the time 1990 ended, it had attracted $1 billion in assets and its first competitor: Overland Express Variable Rate Government Fund, managed by Wells Fargo Bank.

This year, new ARM funds have popped up like dandelions, including entries of two no-load families, Benham and T. Rowe Price, and of other fund organizations such as Federated (Fortress), Keystone, The New England Fund Group, and Pilgrim. In addition, Putnam changed the investment objective of an existing fund, while Dean Witter and Merrill Lynch introduced funds that are similar but don't have to be primarily invested in ARM-backed securities.

Aiming essentially at the same goals -- high income and low share price volatility -- all of the funds sensed an opportunity. rTC They sought to tempt investors who wanted more income than money market funds and less volatility than other bond funds.

In the first nine months of 1991, the group's assets soared from $1 billion to over $5 billion. Franklin alone approached $3 billion. Merrill Lynch's fund exceeded $500 million; Pilgrim's, $300 million.

Could an ARM fund serve your needs? If so, how do you choose one?

To answer the first question, you must understand the dynamics of ARM-backed securities. As interest rates are adjusted -- within specified limits -- on the basis of changes in certain prescribed interest rate indexes, their principal values are less likely to fluctuate than those of fixed-interest securities. But their income is more likely to fluctuate.

Yielding more than money market funds, a fund invested in ARM-backed securities could be an attractive parking place for money, so long as you remember that it's managed to minimize changes in the fund's net asset value (NAV), not to freeze it altogether.

Such funds should protect you against the drop in NAV that you'd risk in a long-term bond fund when interest rates rise. But you also would deny yourself the capital appreciation that even a short- or intermediate-term fund would offer when rates decline.

Choosing an ARM fund requires more than the usual confidence in management -- with the exception of the Franklin fund, no fund has been in operation long enough to have a meaningful record. You also need to give prospectuses more scrutiny.

Performance results for one month are not significant, but total returns and SEC-based 30-day yields for October offer interesting comparisons. As the table indicates, they vary widely, due to differences in investment policies (including credit risk), portfolio management (including hedging practices) and expenses.

Funds differ in the percentage of assets invested in government-related, ARM-backed securities -- for Dean Witter Premier Income Trust, for example, it's less than 5 per cent.

They differ in the selection of those securities.

Especially important: the degrees to which they try to minimize prepayment risk, the timing of interest rate adjustments in their portfolio securities.

Funds also differ in how they invest the rest of their assets. They may include fixed-income mortgage-backed securities or securities backed by other kinds of assets, such as automobile loans and credit card receivables.

All other things being equal, the Benham and Price funds are hard to beat. Neither imposes a sales load, and both have temporarily waived all annual operating expenses, lifting yield and total return.

Adjustable rate mortgage funds

KEY: NA=Not available

NL=No load

8, R=Deferred sales load or redemption fee.

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