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Its Time to Tune-up Your Stable Value Fund! (pg. 2/2)

In theory, the lower the average credit quality, the higher the return of the fund, and in fact five of the funds with above average 12 month returns, including the #1 ranked fund, are also somewhat below the average nearly AA+ credit quality of the universe. However, none of these five are much below the average with the "weakest" of the five still having a solid AA credit quality and the #1 fund being only nominally below the average. Moreover, the fund with the lowest credit quality, AA-, in the entire 27 fund universe also has a 12 month return which is below the average, and there are as many as nine funds with above average credit quality which also have above average returns.

In addition to the value added (or detracted) by your stable value manager’s decisions, part of the explanation for the lack of a consistent relationship between fund maturity/credit quality and fund returns may be due to the fact that credit spreads have been exceptionally tight for the past 2 and a half years and the yield curve has been very flat and even occasionally partially inverted over the past six months or so. These conditions will not persist in the long term and so the "tune-up" of your GIC/stable value fund should include a review of your maturity and quality constraints consistent with the need of the fund to generate more relative return in the future than it may have been called upon to do so in the past.

In addition to weighted average maturity and credit quality, asset allocation decisions by your GIC/stable value manager within the fund can have a significant effect upon its long term return. Our research has led us to conclude that traditional GICs have the ability to outperform comparable quality/duration bonds by 0.40% or more per year on average, and interestingly, although unpleasant at the time, the default rate on GICs is actually much less than that on bonds and the recovery rate is much higher. So the decision you make as to how much to allocate to synthetics to gain industry diversification and how much to the traditional GIC component is critical to the long term performance of your fund.

In our WINTER 1998 issue of the FCM 401(k) UPDATE, we discussed the potential advantages of using other asset classes in addition to bonds within the synthetic component. For decades, managers of endowment funds and defined benefit plan portfolios have recognized that they can increase expected returns while reducing what would otherwise be the risk of a 100% bond portfolio. They do so by diversifying a portion of the bond portfolio’s assets into a spectrum of other asset classes which offer the probability of higher returns but with less than full correlation of their respective market cycles. This same opportunity is available to your stable value manager within the synthetic component of your fund, enhanced by the additional smoothing effect of the book value wrap contract. But as the plan sponsor, you’ll need to determine the amount of latitude to grant (or not grant) to your GIC/stable value manager to take advantage of this opportunity.

In the future, GIC/stable value funds are going to need to provide a larger share of your participant’s investment return, so now is the time to "tune-up" your fund. Average credit quality and maturity are likely to influence the total return as is the allocation to traditional GICs. Asset class diversification within the synthetic component may also be able to reduce risk and increase returns.

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