How to Evaluate Stable Value Funds and Their Managers
Book Value Versus Market Value Returns and the Importance of the Underlying
Fixed Income Securities in Evaluating Stable Value Performance
Analysis of stable value funds and their managers required less consideration in the late 1980s and early 1990s because funds were still buying traditional GICs and using passive “buy & hold” investment strategies. However, the migration away from traditional GICs into active fixed income investments paired with benefit responsive wrap contracts has made the evaluation of stable value funds and their managers a more imposing task.
Stable value is a unique asset class because of the book value accounting treatment. Book value accounting within stable value fund wrap contracts provides a mechanism for smoothing the gains and losses of the underlying investments over time, which enables stable value funds to credit a relatively stable crediting rate. Over very long time periods (ten years or more), the book value returns normally reflect the total return of the underlying investment strategy. Over shorter time periods, however, there are several factors that can influence the crediting rate and associated book value performance.
Impact of Cash Flows on Book Value Performance
Unlike any other asset class where returns are calculated on the basis of market values, book value returns do not provide a complete assessment of how well a stable value fund is being managed. Over short to intermediate time periods, book value returns can be largely impacted by external factors such as sudden changes in interest rates and participant cash flow trends.
As an example, the following comparison of two otherwise identical stable value funds will illustrate this point.
As you can see from this simple example, Fund A will earn a return that is considerably higher than Fund B solely due to the timing of external cash flows. Since cash flows alone can clearly have a large impact on book value performance, it is fair to say that book value returns do not completely reflect the skills of the manager of the fund.
The same concept of cash flows impacting returns can also be applied to entire stable value composites. A manager that is gaining assets during a period of low or declining interest rates will experience downward pressure on their stable value composite returns, as proportionately more assets are being invested at lower and lower interest rates.
A manager with no growth, but lower fixed income returns, may still outperform the growing manager on a book value basis since that manager is not investing incremental assets in a lower interest rate environment.
Lack of Industry Performance Comparison Standards
Other challenges in assessing stable value funds include the absence of an industry standard for investment guidelines and widely accepted stable value performance benchmarks. Due to the varying expectations of individual plan sponsors and the range of management techniques used by their stable value managers, there is not a single style or strategy that is common across all stable value funds. Where traditional fixed income has generally become segregated by duration targets (e.g. short, intermediate, and core and core plus strategy styles), almost all stable value funds are lumped together and viewed as a more unified strategy than actually might be the case. For example, certain plan sponsors may require all assets be rated AAA, while others may allow allocations to core plus mandates. Comparing individual manager book value returns could be like trying to compare an Intermediate Government mandate to an Aggregate strategy. The first portfolio would be very high in credit quality, with limited exposure to spread assets and a shorter duration than an Aggregate strategy, which would be characterized by large allocations to credit and mortgaged-backed securities in addition to a considerably longer duration. Each strategy is going to have unique performance characteristics, and each portfolio will respond differently to changing market conditions. Just as it would be unreasonable to compare the absolute performance of these two strategies, so would it be unreasonable to compare the book value return of the two strategies.
If we place relatively less importance on book value returns, then what factors should drive the stable value manager evaluation process?
Market Value Performance Analysis (Quantitative Review)
Several important factors can be used to differentiate stable value funds and their managers. A key consideration in evaluating the stable value manager is the quantitative review of the market value performance of the underlying fixed income securities relative to their benchmark(s). Over the last several years, performance transparency has been an increasingly important topic in the stable value industry. All of the assets supporting the benefit responsive wrappers are fixed income securities, and should therefore allow for the calculation of market value performance. Stable value managers should be able to provide market value performance of the various components that comprise their investment strategy, which will allow plan sponsors to evaluate risk adjusted returns, performance attribution, etc. This evaluation process will provide great insight into the stable value manager’s fixed income capabilities, which is a key engine of stable value performance. Performance transparency is only a tool, and it is up to the plan sponsors to determine suitability of the overall investment strategy and risk posture of the fund.
Stable Value Focus
Participants nearing retirement may not have the luxury of time to recover from bad investment decisions or to weather turbulent market conditions. It is therefore very important that stable value management be a primary focus of the candidate manager, rather than simply a side business to garner more assets. When reviewing stable value funds and their managers, it is important to consider:
1) Number of Dedicated Stable Value Professionals
The number of dedicated portfolio managers and strategists managing a fund should be commensurate with the existing client base. Dedicated resources will ensure that stable value is a primary business focus.
2) Years of Experience
Commitment to the stable value industry can be determined by the years of experience of the team. Stable value came into existence during the mid-1980s. Therefore, managers with team members that have many years of stable value experience is demonstration that they possess proven track records managing stable value portfolios in diverse market environments.
3) Fixed Income Resources
Successful stable value managers need to be able to expertly manage the underlying fixed income portfolios and convert fixed income performance into book value returns. This requires a thorough understanding of how the wrap contracts are impacted by investment activity and how to realize strong risk adjusted returns within the framework of a high quality mandate.
4) Credit Resources
The fund manager should have an experienced credit team in place to review not only the wrap contract issuers, but also the underlying fixed income securities. Preservation of principal is the primary objective of all stable value funds. It is therefore crucial to have resources in place to protect the portfolio against default. The benefit-responsive wrap contracts do not protect against a default of the underlying securities.
5) Contract Team
The fund manager should have a team dedicated to product development that keeps up to date on benefit-responsive wrap contract features and terms. Stable value has evolved considerably from its infancy. Successful managers employ skilled resources to analyze and implement contract features resulting in high credit quality, liquidity, and investment flexibility.
6) Legal Resources and Compliance
The fund manager should have attorneys on staff to review the legal obligations of the issuing entities. Larger stable value managers typically have multiple attorneys on staff for the purposes of reviewing benefit-responsive contracts and to oversee the internal compliance function.
Portfolio Composition and Risk Profile
This is the most subjective aspect of the stable value manager review. Often portfolio composition and risk are ignored when reviewing stable value performance. Although there is no standard stable value benchmark, general strategies can be compared on a qualitative basis. Most stable value funds have the following investment objectives.
1) Preservation of principal
2) Daily liquidity at book value
3) Competitive and stable return
Wrap contracts do not protect against under-performance, but they can mask under-performance or hide the performance volatility of riskier investment strategies. Wrap contracts do not protect stable value fund returns from the adverse impact of any defaults of the underlying securities. Plan participants bear the loss of defaulted securities under the wrap contract through a lower future crediting rate.
Below are some of the characteristics to consider when looking at portfolio composition and risk profile for stable value funds.
1) Quality
It is very important that the underlying portfolio be high in credit quality. High credit quality is consistent with the goal of preserving principal.
2) Duration Stability
Overall portfolio duration should be stable. As the market value gains and losses of the underlying fixed income securities are amortized over a period equal to the duration of the portfolio, it is important that the duration not deviate significantly because duration volatility contributes directly to crediting rate volatility. Additionally, a portfolio whose duration is lengthening during a period of rising interest rates will under perform a portfolio with a constant duration, all else being equal.
3) Duration Target
Duration determines the rate at which the portfolio will track changes in market interest rates. Higher returns can typically be earned with longer duration portfolios, but longer duration portfolios typically result in a greater difference between the book value crediting rate and the level of market rate return of the underlying portfolio.
4) Diversification
Another way to manage portfolio risk is to diversify exposure to any issuer or issue. In the early days of book value wrap contracts, stable value funds may have had exposure to a relatively small number of securities. As the industry has developed, several managers are using commingled funds that contain several hundred securities within stable value wraps. Diversification can also be enhanced by diversifying among complementary fixed income styles within the overall fund.
Size of Stable Value Manager
The size of a stable value manager is important for two reasons. First, it is an indication of how other plan sponsors and consultants have viewed and accepted the stable value manager’s approach to investing. Plan sponsors and consultants vote with their money. Size is a direct result of how the manager has performed relative to its peers over the years. Second, size enables the manager to gain better execution on the trading of fixed income securities, as well as the clout to negotiate favorable contract terms with the book value wrap providers. With a multi-manager strategy, size is also important because the larger asset base results in lower sub-advisory fees.
Conclusions
Wrap contracts and the associated book value accounting treatment make the evaluation of stable value fund managers a complex endeavor. It is important that the investment philosophy governing the underlying fixed income securities in a stable value fund be consistent with the stable value goals of principal stability, liquidity, and return stability. Stable value fund managers should be evaluated using both quantitative and qualitative measures to ensure that the fund manager has strong fixed income management skills, sufficient scale, and dedicated and experienced resources to effectively address the needs of stable value investors.
About the Author
Andy oversees stable value and fixed income portfolios. Prior to joining Dwight, Andy served as a Senior Account Manager for INVESCO’s stable value and fixed income business. Andy began his investment career at Wyatt Asset Services where he worked as a consultant on stable value investments, pension plan liability transfers, and annuities. Andy is a member of the Portland Oregon Society of Financial Analysts.