Portfolio Management Considerations

Participants, especially older and also younger risk-averse participants, like stable value both for its "preservation of capital", and also for the attractive returns significantly in excess of inflation and money market funds. Participants investing in stable value are insulated from the market volatility of equities and bonds and the anxiety of sudden changes in their retirement assets, as illustrated by the performance charts included on page 5 of this UPDATE. To fulfill these expectations, a stable value manager has a number of critical issues to consider.

While FCM employs several different complementary concepts in managing stable value portfolios, we strongly advocate a significant core allocation to a laddering strategy for GIC and bond purchases for all stable value portfolios. Simply stated, laddering is a strategy of holding securities with equally spaced, comparably sized maturities designed to spread reinvestment risk out over an interest yield cycle.

This results in a continuous stream of cash flow from maturities, which can then be reinvested at then current yields. The maturity ladder also provides for regular portfolio liquidity to satisfy participant withdrawal activity reducing the need for security liquidation and its potential costs. Additionally, portfolios that demonstrate good liquidity management get preferential pricing from GIC and wrap issuers. Due to their historic 0.36% average yield premium, exceptionally low default rate and very high recovery, FCM currently employs a higher allocation to traditional GICs than wrapped bonds. Since FCM has demonstrated particular expertise in managing GIC/buy and hold bond stable value portfolio ladders, we are sometimes retained by very large multi-billion dollar plan sponsors for just such a specialized assignment to complement the evergreen managers they themselves have retained and manage.

Actively managed evergreen synthetics, consisting of wrapped fixed income managed portfolios, offer industry and securities diversification, improved liquidity of the underlying securities and the potential for increased credit quality. But it is critical to employ fixed income managers who have a demonstrated ability to outperform the unmanaged benchmark indices and to overcome the GIC yield advantage mentioned above, as well as the approximately 50 basis points of manager and wrap fees. In the long run, any bond portfolio will produce total returns equal to the income return on the portfolio plus (or minus) the value-added by the manager since capital losses due to interest yield rises have to cancel out capital gains due to interest yield declines or else we would experience negative interest yields over time. Since most fixed income managers, even before the fees, consistently under-perform the benchmarks, it is vital to employ manager(s) who are successful in adding rather than detracting value. In the absence of client preferences to the contrary, we invest approximately 35% of the total stable value portfolio in two or more different, actively managed "evergreen" synthetic portfolios. We select sub-advisors with distinctly different fixed income management styles, so that through style diversification we can achieve less volatility for the evergreen synthetic component in total than would otherwise be the case with just one sub-advisor. Part of the reason for our outstanding performance record discussed elsewhere in this newsletter is that we have the flexibility to retain the very best "evergreen" synthetic fixed income sub-advisors, monitor their performance closely, and replace them as needed without the implicit limitations on our ability to make such changes if we were managing the same assets internally.

In the fall of 2000 when GIC yields were in the vicinity of 7.50% and the Treasury yield curve was actually inverted, we published an article about the challenges of managing a stable value portfolio under the prevailing environment. Since then the average 5-year GIC contract yield dropped over 450 basis points to about 3.00%, and the spread between the one-year and 10-year GIC grew to about 350 basis points. In 2003, the yield curve was steep, but interest rates were at 40-year lows. However, after bottoming out in June 2003, yields have risen substantially to where the high 5-year GIC has risen to about 5.00% and we are now looking at a flat to inverted yield curve once again. Besides analyzing the yield curve when we invest, we think it is vital to compare the level of current yields to near-term historical yields. With the yield curve flat to inverted but with yields relatively high, it is tempting to invest short because there is little incentive to stretch duration. However, this may produce two negative results: 1) experiencing a lost opportunity to lock in relatively higher yields for longer periods of time, and 2) stacking up a larger percentage of a portfolio's assets maturing in the short term thereby making an implicit bet that interest yields will be the same or even higher in the future point than they are when making the investment decision. The converse is also true as it was in June 2003 when the yield curve was so steep. Locking in longer investments would have enhanced the yield in the short run, but would have dragged down portfolio yield for an extended time into the future since relative yields were so low and would have resulted in a severe lag in comparison with money market yields when interest yields began to rise. Therefore, the shape of the yield curve needs to be a consideration, but should be secondary to the level of interest rates in making investment decisions.

At FCM, we employ a proprietary portfolio duration model that takes into account an historical look-back with which to compare the current level of interest yields in determining the appropriate duration target for the overall portfolio, rather than attempting to guess where yields may be in the future. Using GICs in a laddered maturity structure takes advantage of their yield premium and gives the manager the opportunity to shrink duration directly when yields are low so that more money will be available to reinvest when yields begin to rise and the converse. The crediting rate formula in the wrap contract associated with an evergreen synthetic allocation in a stable value portfolio effectively amortizes forward the capital losses that result when yields rise. Therefore, even though the yield on the underlying bond portfolio will rise when interest rates go up, the crediting rate on the wrap contract will lag current yields because it is impacted significantly by the capital losses. And so allocating less new cash flow to "evergreens" until yields are demonstrably above the midpoint of at least the near term historic range of interest rates will minimize the amount of capital losses that are passed through via the wrap contract crediting rate formula.

To keep participants happy it is necessary not only to produce an attractive return with low volatility, but also to minimize the "lag effect" when interest yields are rising, as they may still do in 2006 given that we are only slightly above the midpoint of the near term historical range. Our portfolios are poised to respond to whatever the financial markets do.