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WHAT CAN WE LEARN FROM EQUITY MANAGEMENT?
Robert J. McEvitt, Sr. Vice President and Portfolio Manager

A commentary by John F. Wasik came over the Bloomberg on October 20, 2003 that caught my eye. Entitled "Real Culprit in Fund Scandals is Active Management", this piece asked whether active equity management that involves daily trading is worth the expense and the resulting loss of retirement dollars. Active management is defined as frequent securities trading that incurs significant brokerage commissions, as a result of timing decisions and turnover of securities. Passively managed funds incur far fewer of these costs. Active equity management also incurs much higher manager fees as compared to indexed, passive management. Furthermore, numerous studies show the difficulty that active managers have in outperforming the S & P 500 index in any one year and the infrequency of any one manager even equaling the market over a sustained period of time. In a non-scientific survey of fee only financial advisors across North America, Mr. Wasik discovered that billions in client assets are being switched to passive funds to not only boost returns but to also reduce the high expenses of active management.

Initially, stable value funds most resembled fixed income index funds. Stable value managers (then called GIC managers) constructed portfolios as a diversified pool of GIC contracts that produced a nice even ladder of maturities. The GICs were bought on a net rate basis and held until maturity. The funds were concentrated in the insurance and banking sectors, but they produced attractive blended returns that positively tracked changes in interest rates. They were inexpensive because GIC manager fees were modest, trustee fees were modest and securities custody services were not needed. The stable value industry began to change in response to a few insurance company defaults when plan sponsors realized that the insurance industry was not risk free. Synthetics were developed to allow diversification away from the insurance sector and to increase the universe of available securities allowing for better diversification and lower issuer concentrations. Fixed income bond selection skills were now required to purchase the securities needed to replace GICs in the ladder. "Synthetic GIC" bond transactions entail brokerage commissions, custodial fees, and wrap contract fees, and now stable value managers needed more staff to analyze and conduct transactions in bonds.

The next step in the stable value evolution was to incorporate allocations of managed bond funds in addition to the laddered core of buy & hold GICs and bonds. Stable value funds now enjoy the benefits of the bond manager universe and the fixed income techniques that they bring to the table. Synthetics have resulted in improvements to stable value funds in the form of industry diversification; reduced issuer concentrations; manager style diversification and an investment universe as wide as the public bond markets. However, within each managed bond allocation, expenses multiplied. Bond manager fees are considerably higher than the former level of pure GIC manager fees. By definition, bond managers trade bonds, so transaction costs in the form of brokerage commissions, higher custodial fees and wrap fees erode the earnings power of participant dollars. From a performance standpoint, it is hoped that active bond managers will provide enough alpha to overcome the higher expenses however, bond managers have the same problem that active equity managers face; outperforming their indices and their peers on a consistent basis.

Our studies show that high GIC yields exceed the yield to maturity of a comparable quality/duration bond by as much as 0.38% on average. GIC yields are net of all fees so after considering the cost of synthetically wrapping a bond at 8 basis points, the spread advantage of a GIC over a bond grows to 0.46%. After adding in the cost of custody of perhaps 3 basis points the GIC yield advantage grows to 0.49%. And higher management fees and transaction costs further reduce the performance of actively managed synthetic structures, so there is a lot of alpha that needs to be added to equal a pure GIC portfolio's performance. In fact, when you compare a 100% GIC portfolios to 100% managed bond portfolios, the net yield advantage of the GIC portfolio is up to 80 basis points over the similar quality/duration bond portfolio.

Nonetheless, FCM doesn't view the GIC/synthetic debate as an either or proposition. Each has attributes that positively contribute to the construction of a well-diversified, high quality, stable value portfolio. Unfortunately, we have observed that much of the stable value manager community, perhaps driven by fees, is moving away from any use of GICs (only 15.4% on average) and in some cases doesn't even employ the use of a laddered core of buy & hold investments. However, in the 2002 Stable Value Investment & Policy Survey published by the SVIA, it is interesting to note that In-house managers still have the largest allocation to GICs of any group surveyed - on average 40%. Some of the surveyed companies are Citigroup, duPont, Eastman Kodak, Federal Reserve, General Motors, Goldman Sachs, Halliburton, US Steel and others. Interestingly, the Federal Reserve has 100% of its stable value fund assets invested in GICs. In addition, according to the SVIA survey, the in-house managed funds outperformed externally managed funds by 50 bp on average for the twelve-month period ending 12/31/2002.

Excluding GICs from a stable value fund means not taking advantage of their high quality (policyholder obligations of the second highest quality sector out of the 13 industry groups followed by S&P that are senior to all other debt), yield premium of 38 basis points above similar duration and quality public bonds, and their unique attributes including book value treatment, no capital losses when rates rise, and their ability to be individually negotiated when purchased and renegotiated later if need be, as a private placement bond. Diversification and high quality investments are absolutely imperative in Stable Value Funds but just as in equity management, fees can significantly erode a participant's ultimate retirement accumulation. Therefore, FCM advocates the use of a significant allocation to a laddered core primarily comprised of a healthy dose of GICs, for their ability to reduce fees and boost performance. Their inclusion does not have to introduce undue risks but their inclusion distinguishes them positively from simply wrapping a bond portfolio and calling it a stable value portfolio.