How Asset Allocation Models Handle Stable Value Funds

By Randy Myers

Given their hybrid nature–they generate returns comparable to those available from intermediate-term bond funds, but with low volatility similar to money market funds–stable value funds have never been particularly easy to account for in asset allocation models. But leading financial services firms appear to have found solutions that make them comfortable.

Mutual fund company Fidelity Investments, for example, incorporates stable value funds into the models it uses to construct 401(k) portfolios for retirement plan participants who sign up for its Portfolio Advisory Services at Work program (PASW), which gives Fidelity discretionary authority to manage a participant’s 401(k) investments. About 50 percent of the Fidelity-administered 401(k) plans use the PASW program, Martinez elaborated. He said that more half of the plans in PASW have a stable value investment option available to their plan participants.

“Our overall construction process is pretty straightforward,” said Fidelity’s Bryan Martinez, vice president of product management planning and advisory services, at the 2010 SVIA Fall Forum. “We use the Barclays 1-5 Year Bond index as a proxy for stable value in considering risk, and if a stable value option is available in one of the plans we manage, we always use it to cover 100 percent of the cash position.”

In addition, Fidelity also uses stable value funds for some portion of participants’ bond portfolios “when the risk-return tradeoff is optimal.” It also uses stable value funds to counterbalance the risk of holding company stock in a participant’s portfolio.

Because portfolios in the PASW program become more conservative as participants age, Martinez added, they tend to have higher and higher allocations to stable value funds over time.

Martinez was one of three speakers to address Forum participants on the use of stable value funds in asset allocation models. He was joined by Hal Ratner, senior investment analyst for fund research firm Morningstar Associates LLC, and Omar Aguilar, head and vice president of portfolio management for Financial Engines, an independent investment advisory firm.

Ratner said his firm’s asset allocation model treats stable value as a generic entity, meaning that it assigns the same characteristics to all stable value funds. It treats them as a mixture of cash and bonds, with an additional component representing the value of the wrap contract that backs investor access to book-value returns.

This approach is workable, Ratner said, because almost all defined contribution plans have only one stable value fund. Accordingly, he said, there’s no imperative to be able to compare one stable value fund to another in building an investment portfolio for an individual retirement plan participant.

Nonetheless, Ratner said Morningstar is working on a new approach to modeling stable value funds that would treat each fund as a unique entity. That’s something that Financial Engines has been doing for some time. The company has 300 plan sponsor clients, who collectively have 190 different stable value funds available to participants in their retirement plans.

Financial Engines’ approach, Aguilar said models expected risk and return properties for each fund in a process that factors in exposure to six different fixed income asset classes. It also models the crediting rate for each fund and bases its recommendations to investors on the long-run economic characteristics of each fund’s underlying assets. The model does not arbitrage crediting rates and market interest rates, he said. He said that participants using Financial Engine’s advice service currently have about $1.9 billion invested in stable value funds.

Having stressed the consistency of Financial Engines’ allocation to stable value, Aguilar said that the firm does not rebalance portfolios away from stable value funds during periods of extreme market volatility, such as when their market-to-book-value ratio is under pressure. In fact, he said, an analysis of the volatile 2008-09 time period showed that Financial Engine’s model actually increased allocations to stable value as retirement plan participants’ tolerance for risk decreased.