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Asset Allocation Models: Still Searching for Stable Value

Imagine running for political office without having your name on the ballot. That's how many providers of stable value products feel as they compete with mutual fund companies for investor dollars.

The problem lies with the asset allocation models that fund companies, brokerage houses and other financial services firms are making available, with increasing frequency, to individual investors. The models are designed to help investors decide how to divvy up their money among the major asset classes depending upon their risk and return objectives. But most of the models don't treat stable value products as a distinct asset class; instead, they lump them together with bond funds. As a result, the models are incapable of recommending that investors allocate any of their money specifically to the stable value sector.

That's a troubling notion to the stable value industry, which notes with pride that stable value products produce returns that are comparable to intermediate-term bond funds, but, thanks to their principal guarantee, expose investors to less risk.

Nonetheless, several speakers at the SVIA 1999 National Forum cited numerous hurdles to having stable value funds recognized as a distinct asset class, most notably the paucity of historical performance data for the sector. Although stable value products have been around since the late 1970s, when guaranteed investment contracts became popular, the current crop of stable value products, which includes synthetic GICs, are best represented by benchmarks that go back only about 10 years, said Lori Lucas, an investment consultant with Hewitt Associates. By comparison, data on stocks, bonds and cash are readily available going back more than 70 years.

"Because we've had a very benign interest-rate environment, the existing data for stable value tends to exhibit very low standard deviation (volatility) and high returns," explained Lucas. "So that makes stable value look very attractive versus a bond benchmark such as the Lehman Brothers Aggregate index. Put that data into an (asset allocation) optimization model, and you end up with almost nothing (of your fixed-income allocation) in bonds, and everything in stable value."

To create more diversified portfolios, plan sponsors who've tried to model stable value funds typically use a proxy, such as Treasury bills, even though, in that case, they know the returns will be lower, Lucas said.

Scott Lummer, chief investment officer for the 401(k) Forum, an Internet-based education resource for 401(k) investors, said that in addition to the problem of finding historical data, his firm doesn't treat stable value as a unique asset class for three other reasons: the inconsistency in the average maturity of stable value fund holdings, which he indicated range from one year to seven years; inconsistency in the type of securities in which stable value funds are invested; and the similarity of most stable value funds to short-term bond funds.

Lummer said that that when considering whether to recommend a stable value fund to 401(k) participants, his firm looks at the historical real returns of that specific fund. His firm also considers the maturity and credit risk of the securities held in the fund; the credit risk associated with the wrapper (the financial institution guaranteeing the principal and accumulated interest of the fund and the ability of participants to make withdrawals and transfers at book value); and the exit provisions of the fund, such as withdrawal limits and equity wash rules.

"Frankly, I don't know why you want to be your own asset class," Lummer told his listeners at the National Forum. "Over the past 10 years, stable value has done very well without that distinction."

Paul Lohrey, a stable value portfolio manager for Vanguard Group, the nation's second-largest mutual fund company and an administrator of 401(k) plans for corporate clients, expressed a similar sentiment. Based on investor behavior, he said, recognizing stable value as a separate asset class is simply "beside the point."

"Asset allocation models already incorporate cash and bonds, and investors in defined contribution plans have shown that they don't like them anyway," Lohrey observed.

Lohrey said that where stable value funds are offered in retirement plans for which Vanguard provides investment advice to participants, his firm treats them as an alternative to fixed income and/or cash, but doesn't explicitly model them. He said Vanguard does recognize that stable value funds can "contribute substantially to portfolio balance."

Lummer, despite his arguments against treating stable value as a distinct asset class, said his firm also recognizes the value of stable value funds, and often recommends them.

"We allocate about 75% of the fixed income (portion of our clients' accounts) to stable value funds as opposed to money market or bond funds," Lummer said. By contrast, he said, most financial advisors ignore stable value, or "treat it as a money market fund substitute, which receives a low allocation for long-term investors."

If stable value were treated as a separate asset class, it might help to erase that bias against stable value funds. But as the remarks of Lohrey, Lummer and Lucas so clearly demonstrated, that day may not come anytime soon.

Read Next: Stable Value: The Best-Kept Secret in 401(k) Plans?