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Will the Mutual Fund Scandal Make Equity Washes Easier to Swallow?

The trading restrictions that have resulted from the mutual fund scandal are intended to prevent future abuses that harm a majority of shareholders. That's good news for investors. Indirectly, the new restrictions could also spell good news for stable value providers by making equity washes easier for some plan sponsors to swallow.

Historically, equity washes have been required by stable value providers on plans with competing funds. A competing fund is any fund, usually a money market or short-term bond fund, that subjects a stable value fund to the risk of disintermediation by presenting arbitrage opportunities. The equity wash mandates that any monies transferred out of the stable value fund and into a competing fund option must sit in an equity fund for a period of time, usually 90 days before the transfer is completed.

This rule protects the stable value provider, to be sure, but it also protects remaining stable value fund participants. How? First, it is arguably true that only reasonably sophisticated investors would actively engage in arbitrage to begin with. Second, it is also arguably true that a majority of plan participants would not consider themselves sophisticated investors. Since all (unless there is no cash buffer) stable value options are at least partly participating in nature, meaning all participants share in the gains and losses of the underlying portfolio. This means that arbitrageurs, the relatively sophisticated few would benefit at the expense of the remaining longer-term investors, the probably less sophisticated many, who stay in the stable value option.

Assume, for example, that an arbitrage trade occurs when the market value of the stable value fund is below its book value. The arbitrageur would collect this difference at the expense of the remaining investors, whose market value to book value deficit would further grow to their detriment, thus lowering their crediting rate.

Many plan sponsors offer stable value as their only low-risk option, since it has a proven record of significantly higher returns than nearly any other principal-protected option. For these plans, no equity wash provision is needed. There are still plans, however, that prefer to include, in addition to their stable value fund, options such as money market funds and short bond funds, even though they historically have inferior risk/return characteristics as compared to stable value. Most stable value providers either refuse to issue into such plans, or they require an equity wash or similar remedy that eliminates any arbitrage potential.

In some cases, stable value restrictions on competing funds are resisted by plan sponsors who are concerned about short-term operational strains on systems associated with monitoring these restrictions and/or the difficulties of explaining the restrictions to participants. These are legitimate concerns, of course. But the likely upshot of focusing on such concerns is that the stable value provider will simply refuse to issue into the plan, thus plan participants are deprived of stable value's superior risk/return characteristics.

This is where trading restrictions brought about by the mutual fund scandal may prove to be beneficial for stable value funds. One of the primary thrusts of the mutual fund scandal has evolved around late or illegal trading of international equity mutual funds. Since almost all major 401(k) plans have an international option, almost all plans must adapt their operating systems to comply with these new restrictions. In turn, these new restrictions have forced plan sponsors to educate participants about these new rules.

In other words, when plans come into compliance with the new international mutual fund trading restrictions, two of the primary objections to stable value competing fund restrictions will have been eliminated.

If the plans that have competing funds can be shown that the objective of equity washes is to protect the vast majority of the participants from adverse experience at the hands of a few arbitrageurs similar to how the new mutual fund restrictions protect buy-and-hold fund participants from trades that benefit a few at the expense of the many, then stable value wins. And, importantly so do the vast majority of plan participants.

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