Mortgage-Related Investments Are Catching On
No-load mutual fund companies have finally joined the ARMs race, and that’s good news for yield-conscious individuals who don’t want to pay a sales charge when they invest.
With short-term interest rates at their lowest levels in years, people are clamoring for attractive yet safe places to stash their cash. ARM, or adjustable-rate mortgage funds, with current yields in the 7% to 8% range, fit the bill pretty nicely. These vehicles pay more than certificates of deposit or money market funds, while subjecting investors to less risk than most short-term bond funds. “ARM funds are definitely the hot area right now,” says Don Phillips, editor of Morningstar Mutual Funds, a Chicago investment publication.
The Franklin Group of San Mateo, Calif., came out with the first ARM fund in 1987. However, the idea took awhile to catch on. After Franklin proved it could work, other load-fund companies started to unveil competing products at the beginning of this year. Many come with sales charges of 4% or so, which obviously amounts to a fair-size hurdle on an income product. Excluding sales fees, the average ARM fund delivered a 9.1% total return during the past 12 months, Lipper Analytical Services reports.
In early September, Benham Capital Management of Mountain View, Calif., became the first no-load group to enter the ARM fray and has since attracted an impressive $175 million by appealing to investors who don’t want to pay a sales commission. More recently, Baltimore-based T. Rowe Price, another big no-load outfit, started an adjustable-rate mortgage fund.
There are 13 ARM funds, reports Lipper, compared to just the Franklin portfolio at this time a year ago. Yet Franklin’s fund remains the largest, with $3.2 billion of the total $5.2 billion in assets for the group as a whole.
The fact that no-load companies have unveiled ARM funds indicates that the concept is a sound one, Phillips says. “Load companies are typically the innovators in the mutual fund business, and no-load groups follow with their own products in categories they think will pan out.” This explains why there was never a Fidelity Option Income Fund or a Vanguard Government Plus Fund, he says, in reference to two fad categories.
ARM funds strive to bridge the risk-return gap between money market and short-term bond funds. They invest in bond-like securities backed by pools of residential mortgages. Many of these securities are issued and guaranteed by federal housing agencies, such as the Government National Mortgage Assn. (Ginnie Mae). This gives the securities top ratings for credit-worthiness, although they can fluctuate in price.
ARM portfolios aren’t the only type of mutual fund to hold mortgage-backed securities, but they are unique in their short-term focus. The rates on ARMs typically readjust every few months, which makes them very conservative, with little price volatility. At the same time, they pay higher yields than short-term Treasury bills and the mutual funds that hold them.
For example, Benham’s ARM fund, which now yields 7.3%, debuted at $10 a share and has stayed within 10 cents of that level ever since. Stephen Brown, a co-portfolio manager, figures that the fund’s price would rise or fall by only 15 to 17 cents for each percentage point change in interest rates. This low volatility means there’s not much chance for capital gains. But investors--especially those transferring money from bank accounts--seem more interested in safety and yield than appreciation potential.
It’s important to emphasize that ARM funds aren’t as stable as money market funds, which have a virtually flawless record of avoiding losses for investors.
“I have a problem with ARM funds that are pitched as a money fund alternative,” Phillips says. He points out that the Securities and Exchange Commission sets tight standards for what a money fund can and can’t invest in; the requirements for ARM portfolios aren’t as strict.
In short, ARM funds can--and do--fall in price from time to time. Plus, they can be stripped of their most valuable bonds during periods when homeowners are busy trading in their adjustable loans for fixed-rate mortgages.
“A worse-case scenario for us would be a dramatic rise in short-term rates with long-term rates staying the same,” says Brown, since that would result in widespread ARM refinancings. In addition, the funds’ yields will tend to lag during periods of rising interest rates.
Still, ARM portfolios fill a segment in the market for low-risk income products. And the emergence of no-load funds is a happy development for people who don’t want to go through a broker, at a cost that might offset a half-year’s yield or more.
New Funds on the Block This may be a recession year, but mutual fund companies apparently haven’t noticed. Net sales are running nearly 40% above last year’s pace, and more than 200 new funds have hit the streets. Some of the more unusual choices include:
The Franklin California 250 Growth Fund (4.5% load), which invests in an index of 250 in-state companies. The fund is brand new, but Franklin says the index has gained more than 40% this year.
The G. T. Latin America Growth Fund (4.75% load), which invests in Mexico and four South American countries. This fund, launched in August, has $135 million in assets. Because of the illiquid nature of the Latin bourses, the portfolio has temporarily closed its door to new investors but might reopen in the spring. It’s offered by G. T. Capital Management of San Francisco.
The Scudder Short-Term Global Income Fund, the first no-load portfolio of its kind. Funds in this category hope to capitalize on higher yields available in other nations, while using hedging techniques to minimize the currency risk. The price of the Boston-based Scudder fund hasn’t varied by more than 3% since its launch date in March, despite a strong year for the dollar.
Also of interest is Shearson Lehman Bros.’ new Trak program, which isn’t a mutual fund but rather a lower-cost wrap-fee account. Trak offers professional management and diversification among 11 different mutual funds, along with personalized attention from a broker. Typical wrap accounts might charge 3% in annual fees and require $100,000 or more, but Trak costs 1.5% a year, with a $10,000 minimum through Dec. 31 ($25,000 thereafter).
