Ginnie Mae Funds Offer Investors a Safe Harbor

· Not all are alike: While it may seem funds investing in the same narrow category of government-guaranteed mortgages would yield positive returns year after year, things can go wrong. For example, Putnam U.S. Government (PGSIX) lost nearly 5 percent last year. Alongside its Ginnie Mae holdings, the fund invested in collateralized mortgage obligations whose market value sank because of their high risk compared with other mortgage-related securities. At least 80 percent of a fund's portfolio must be in Ginnie Maes to include GNMA in its name. Some funds bearing "government" but not GNMA in their name carry lesser amounts of Ginnie Maes, typically including other government securities such as bonds in mortgages backed by Fannie and Freddie. While the government's current control of those two agencies temporarily extends a virtual government guarantee, Fannie- and Freddie-backed bonds lack the explicit guarantee that Ginnie Maes have always enjoyed.

· Rate volatility: Sudden changes in mortgage rates can make Ginnie Maes complex investments. Fund managers put cash to work by sifting through the market for Ginnie Mae-backed mortgages of varying maturities, such as 30 years and 10 years, and placing bets on the pools of mortgages offering the best prospects. Success can hinge on managers' often unreliable forecasts of where rates will go.

For example, the recent rate drop has prompted a wave of refinancing among borrowers shifting to less-expensive mortgages, creating prepayment risk for Ginnie Mae funds. When refinancing activity spikes, some of the higher-rate mortgages in Ginnie Mae funds are replaced by lower-rate mortgages, which reduces fund returns.

An opposite challenge emerges if mortgage rates rise. Then, Ginnie Mae funds face extension risk -- the prospect that market values for mortgage-backed securities bought when rates were lower will drop as investors seek higher returns from mortgages with newly increased rates.

· Costs count: With Ginnie Maes typically earning only modest returns, expenses can eat away much of it. Harry Milling, a fund analyst with Morningstar Inc., said cost should be the top consideration in comparing Ginnie Mae funds. "Think of these like you think about municipal bonds," Milling said. "Muni funds are kind of all investing in the same thing. What is going to make the big difference is the cost."

The top pick among Ginnie Mae funds for both Milling and Lipper fund analyst Jeff Tjornehoj is Vanguard GNMA (VFIIX). It's by far the biggest Ginnie Mae fund, with $29 billion in assets, and also has the lowest expense ratio (0.21 percent) along with a category-beating three-year average annual return of 6.09 percent.

Tjornehoj advises giving slightly higher weight to a Ginnie Mae fund's performance record than its expenses. He argues the funds are sufficiently complex with mortgage rate volatility that a savvy manager can eke out markedly better returns.

"You can certainly have a fund with low expenses that just looks to be out of place in various markets," he said.

Tjornehoj advises playing it safe, since many investors rely on Ginnie Mae funds to help limit risk as they get close to retirement.

"Look at their performance next to their peers," he said. "If they're particularly volatile, that may not be the reason why you got into a Ginnie Mae fund."