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Non-Traditional Assets in Stable Value Funds

In today’s environment, money market funds are often out-yielding stable value funds, DC plans are more frequently replacing DB plans as an employee’s primary retirement savings vehicle, and tight yield spreads are limiting managers’ ability to generate excess returns. These factors and others are all driving an increased appetite for safely and prudently enhancing stable value fund returns. The most common approach is to turn to non-traditional asset classes, which raises an important question: Is enhancing stable value returns through non-traditional asset classes a prudent move for plan sponsors and investors in stable value funds?

Deutsche Asset Management believes the answer to this question is yes, with a caveat. The caveat is that not all non-traditional asset classes or investment strategies are appropriate for a stable value fund. Many non-traditional assets require a substantial trade-off of lower credit quality or reduced liquidity in order to enhance returns. While those trade-offs may be acceptable in limited amounts, they often don’t provide the most efficient way to achieve the desired return enhancements. How, then, can non-traditional assets be deployed to most efficiently and prudently enhance stable value returns?

To answer this question, stable value managers and plan sponsors have historically looked to trends in defined benefit investing. A big trend over the last five years has been the separation of alpha and beta, and increased acceptance of using alpha overlay strategies to enhance returns. While alpha overlay strategies differ significantly in implementation, Deutsche Asset Management believes that a prudent and risk controlled portable alpha overlay can be an excellent source of return enhancement for a stable value fund.

An alpha overlay is an investment strategy that is combined with an existing evergreen fixed income portfolio and covered by the wrapper agreement to create a prudent and effective way to enhance stable value fund returns with little incremental volatility. A prudent alpha overlay strategy for a stable value fund should have the following characteristics: (i) the source of the return enhancement shouldn’t come from lowering credit quality, (ii) it should not sacrifice liquidity, (iii) it should be governed by a stringent value-at-risk budgeting approach so risk is always quantified and understood, (iv) it should demonstrate a successful track record of generating positive alpha, and (v) it should add little volatility to the fixed income returns of the fund by having a low correlation to traditional stable value strategies. The question becomes what type of non-traditional assets can be utilized to achieve all of these objectives for the alpha overlay strategy? Government bond and currency markets in developed and creditworthy countries around the globe offer an excellent solution. These markets are typically extremely liquid and require very little credit risk to make an investment. By taking relative value views on these markets that combine long and short positions, a well-managed, portable, alpha overlay strategy adds very little volatility but can add significant return enhancement.

A good alpha overlay strategy is additive to the underlying fixed income portfolio where you want it to be, in the returns, but not additive where you don’t want it to be, in the volatility. This is achieved only when the returns from the alpha overlay have a very low correlation with the underlying fixed income portfolio. Investing in very liquid and high quality government and currency markets is an effective way to achieve these low correlation returns, because these markets respond more to the ebbs and flows of foreign market economies as opposed to the U.S. market economy. This fundamental difference in driver-of-market returns naturally generates alpha returns with low correlation to domestic fixed income markets.

Deutsche Asset Management has taken a leadership role in using alpha overlay strategies to enhance stable value fund returns for over seven years, with very compelling results. Seven different wrapper issuer institutions (both banks and insurance companies) have done extensive due diligence on the strategy and concluded that they are comfortable issuing a wrapper contract that puts their balance sheet at risk to provide book-value coverage for the strategy. This is a testament to the confidence that these institutions have in the risk management of the strategy and its appropriateness for a stable value fund. Prudent and well-managed portable alpha strategies in non-traditional markets can and do provide an effective way of enhancing stable value fund returns in a risk-controlled framework with minimal incremental volatility, credit risk, or liquidity risk.

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