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ARM funds: good yields but some risks Still new, they need to be tested further


New York -- Looking for an alternative to a money-market mutual fund? Many investors are jumping to the new funds invested primarily in adjustable-rate mortgages. The first of these funds broke ground four years ago. Now there are 19, with more than $5.3 billion in assets, according to Lipper Analytical Services.

Current yields on ARM funds run between 7 percent and 8 percent, compared with a 30-day compound average of 4.4 percent on money-market funds. Some ARM funds offer check-writing privileges, just as the money funds do. ARMs are guaranteed against default by the U.S. government or a government-backed agency.

But before you drop this column and telephone your broker, understand that the similarities between ARM funds and money-market funds are purely superficial.

ARM funds invest the majority of your money in securities backed by adjustable-rate mortgages. When short-term interest rates change, ARM rates do too, generally with a lag of six months to a year. So the current yields on ARM mutual funds gradually align themselves with the market.

The funds' underlying values are expected to remain fairly stable. But they do carry risks:

* They don't necessarily preserve your original capital. The oldest ARM fund, Franklin Adjustable U.S. Government Securities, has lost a few cents in share value every year since 1988.

The interest earned has more than covered that loss. Franklin's total return in fiscal 1991 (counting gains from reinvested interest, a 6-cent loss in net asset value and ignoring sales charges), came to 8.67 percent after annual management fees.

* Upfront sales charges chop your yield, and most of the ARM funds charge them. Adjusting for its 4 percent sales charge, the Franklin fund returned only 4.28 percent in fiscal 1991. The Putnam Adjustable Rate U.S. Government Fund costs 4.75 percent up front. Some funds charge nothing extra when you buy but levy an annual sales and distribution fee (known as a 12b-1), plus an exit fee if you sell too soon.

If you're interested in an ARM fund, choose one with no sales charges. Two possibilities: the Benham Adjustable Rate Government Securities Fund in Mountain View, Calif., (800) 472-3389, or the T. Rowe Price Adjustable Rate U.S. Government Fund in Baltimore (800) 638-5660.

* Typically, the share prices of mortgage funds rise when interest rates fall. But with ARM funds, that's not necessarily the case. The Franklin fund is a good example. It has lost 18 cents a share since 1988 -- not much, but a loss nonetheless.

The culprit here is mortgage prepayments. Many ARM-fund managers bought their ARMs for more than face value. When people prepay those loans, as they are doing now in huge numbers, they pay only face value. So investors lose money. Furthermore, when mortgages are prepaid in a period of falling ++ interest rates, that money has to be reinvested at lower rates, which reduces your yield. T. Rowe Price's ARM fund, currently yielding 7.3 percent, may soon drop to around 7 percent, says Price's Steve Norwitz.

Some ARM funds contain more hidden losses than others. T. Rowe Price's Heather Landon suggests that you call the fund and ask for its "average coupon rate," which reflects the base rate of the underlying mortgage. (Typically, the funds tell you only the average yield, which includes any changes in share value.) Then ask the fund for the current cost-of-funds-index (COFI) rate, which reflects mortgage rates in the West but is also used in other parts of the country.

If the ARM fund's rate is much above the COFI rate, it contains a lot of built-in losses.

When interest rates rise again, ARM fund values will decline further, because ARM mortgage interest rates won't be adjusted fast enough to keep up with the market. So you're always counting on high rates of interest to cover your capital losses.

* The funds may buy things besides ARMs that carry more risk. The Putnam fund, for example, may invest up to 20 percent of its assets in foreign securities -- a fact mentioned in the prospectus but not explained in the sales brochure.

ARM funds have other catches that I don't have the space to explain. They're currently paying much more than money funds, at an acceptable risk to principal. But because they're so new, they haven't been tested over a full interest-rate cycle. You might want to wait for more history before signing up.

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