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Hurdles Outlined for Stable Value in Mutual Fund Platform

Over the past few decades mutual fund companies have introduced all sorts of products aimed at fixed-income investors: government bond funds, municipal bond funds, high-yield bond funds, even funds that invest in adjustable rate mortgages. But all of them, says Morningstar Associates LLC President John Rekenthaler, have merely been an asterisk to money market funds, which have come to be prized by investors for their implied guarantee of principal and dependable if generally modest returns. As of August 2002, Rekenthaler says money market funds held assets totaling $2.1 trillion, versus $1.1 trillion for all other types of fixed-income funds combined.

The most recent addition to the lineup of fixed-income mutual funds is the Stable Value mutual fund, the first of which appeared in 1998. Whether these funds can make a bigger dent in the dominance of money market funds, Rekenthaler says, will depend upon the response of the industry and investors to these issues:

• Trading restrictions. Will retail investors accept the trading restrictions, asks Rekenthaler, that most Stable Value mutual funds impose on their shareholders during periods of sharply rising interest rates?

• Principal protection. To what extent, Rekenthaler asks, will Stable Value funds meet their implicit guarantee to preserve a shareholder's principal?

• Changes in the yield curve. Although Stable Value funds have a long history of strong performance in all sorts of interest rate environments in the 401(k) marketplace, Rekenthaler says investors will want to see how the new Stable Value mutual funds perform across a full market cycle's worth of changes in the yield curve.

• Management discipline. Funds in other sectors of the fixed-income marketplace have been hurt in the past by rogue management techniques, warns Rekenthaler, typically when they invested too aggressively in an attempt to attract assets. Stable Value managers can't make that mistake.

• Marketing. Will the Stable Value industry be able to police its promises to investors, Rekenthaler asks, and avoid hyperbole and overselling?

• Media perceptions. To really gain headway, Rekenthaler suggests, Stable Value funds would have to occupy, in the minds of the media, the high road now held by money market funds. One challenge for the funds' operators, he says, will be to keep costs at levels that financial writers and investment analysts won't find excessive. "When you get over 100 basis points on a short-term investment, analysts and the media are going to have a problem with that," he says. "Seventy-five basis points is not cheap, but can be acceptable for a well-run fund. We like to see 50 basis points."

Rekenthaler himself has considerable ability to influence investor opinion. He oversees development and marketing of Morningstar ClearFuture, an internet-based service that provides investment research, education and guidance or advice to help individual investors plan for retirement. Speaking at the SVIA Forum, he said Stable Value mutual funds have much going for them in their bid for widespread acceptance by retail investors, primarily their high yields relative to money market funds and their low volatility relative to other types of bond funds. "But like many failed fixed-income products before them," he warns, "Stable Value is hard to explain and easy to oversell."

Rekenthaler's comments dovetailed with those made at the SVIA Forum by various investment firms that market Stable Value mutual funds. They report strong asset growth for their funds, but also indicate that the industry must continue to work hard to educate both investors and investment advisors about the unique attributes of the products. "We have ridden a wave of declining interest rates, and now will be looking at a rising rate environment," observes Daryl Dennis, vice president of fixed-income investments for ICMA Retirement Corporation, which launched its Vantagepoint Income Preservation Fund in December 2000. "Our industry will have to prove that it can perform in a difficult market." His firm's outlook for market conditions next year includes not only rising interest rates but also modestly higher inflation, modestly rising equity prices and a weaker dollar.

Dennis says the Vantagepoint Income Preservation Fund has drawn in approximately $460 million in assets. The fund is marketed exclusively to participants in public retirement savings plans and IRA investors. Thus far, the vast majority of its assets have come from the public plan market; the fund is offered in approximately 6,000 plans serving approximately 88,000 investors.

Deutsche Asset Management manages the world's oldest Stable Value mutual fund, the Scudder PreservationPlus Income Fund, and it also grew phenomenally in 2002. John Axtell, managing director and head of the Stable Value management group at Deutsche Asset Management, says the assets rose from $1 billion in January 2002 to $1.6 billion by September 2002. Some of the credit goes to their performance. The fund outperformed money market funds by a handsome margin.

Axtell says he sees tremendous opportunities for Stable Value mutual funds in the broker-sold small 401(k) plan market, in the IRA rollover market and in the 529 college savings plan market. He also said that while some industry observers worry about what will happen to Stable Value funds when interest rates do start rising, he believes a rising rate environment would actually be beneficial in that it would drive some investors into Stable Value mutual funds from traditional bond funds. "Retail investors will see bond funds producing negative returns and they will react," he said.

Finally, Axtell says his firm's Stable Value mutual fund has been garnering rave reviews from independent investment advisors who market it to their clients, including one advisor who likened it to "a money market fund on steroids."

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