By Randy Myers
David Babbel, Professor of Finance and Professor Emeritus of Business Economics and Public Policy at the University of Pennsylvania’s Wharton School, has been a fan of stable value for the past decade. He has written several papers on the asset class since 2007, the first sponsored by the SVIA and the rest written just because he finds the topic interesting. He is now contemplating producing yet another paper, and continues to conduct research on the asset class. His interest goes beyond the theoretical, though. In speaking engagements, Babbel likes to remind his audience that he has invested his own money in stable value funds in his retirement plans at Wharton and global consulting firm Charles River Associates, where he is a Senior Advisor.
In his earliest papers on stable value, written in collaboration with Miguel Herce, Babbel found that for investors with virtually any level of risk aversion, stable value had proved itself to be more attractive than either bonds or cash over the past few decades. He also demonstrated that adding stable value to an equity portfolio had been a better diversification strategy than adding either bonds or cash.
Speaking at the 2016 SVIA Fall Forum, Babbel said his newest research has uncovered several important new findings. It is distinguished from his previous work, he noted, because it relies for the first time on forward-looking expectations for stable value and fixed-income returns rather than past performance. That is important, he argued, because fixed-income returns over the past two and a half decades were skewed by an extraordinary bull market in that asset class—and stable value funds, of course, invest primarily in fixed-income securities. From 1990 through last year, Babbel noted, yields on long-term bonds fell to less than 2 percent from more than 9 percent, producing an average of about 3.5 percentage points of additional return each year over and above bond yields. With interest rates so low now, he said, it would be unrealistic to expect bonds to deliver that extra annual 3.5 percentage points of return in the years ahead, and therefore unrealistic to use the fixed-income returns of the past two and a half decades to compare stable value with other asset classes, or to calculate how stable value should fit in a model portfolio going forward. To perform his forward-looking analysis, Babbel used past levels of volatility as a measure of risk, but substituted the current yields of bonds to serve as a proxy for expected future returns.
Before delving into the implications of all this at the SVIA forum, Babbel used a simple mean-variance analysis to demonstrate, as he has in earlier studies, that adding stable value to a diversified investment portfolio has produced a more efficient investment frontier. In fact, for most investors, including those with a high tolerance for risk, an optimal portfolio derived from mean-variance analysis would have consisted almost entirely of stable value, long-term bonds, and small-company stocks. That would leave out not only large-company stocks but also money market funds and intermediate-term bonds. “So much for the S&P 500, so much for target-date funds, so much for lots of stuff,” Babbel quipped.
Babbel reminded his audience that mean-variance analysis, while popular, is inherently flawed, in that it penalizes an asset class as much for positive variances as it does for negative variances. Sortino ratios, which measure risk-adjusted return while penalizing only for negative variances, can provide a more meaningful picture of asset class performance. By that measure, Babbel said, stable value has provided about 20 times more “bang for the buck,” or return in exchange for risk, than other major asset classes.
Babbel’s favored tool for comparing stable value to other asset classes, though, is stochastic dominance analysis, which says in layman’s terms that the more money you get, the more you like it. It shows, as Babbel has previously documented, that stable value dominates both money market funds and intermediate-term bond funds for risk averse investors, regardless of how risk-averse they are.
In his latest work, Babbel extended his analysis of stable value by using dynamic portfolio optimization to create optimal investment portfolios for any given level of risk. He focused, though, on the vast majority of people who are neither extraordinarily risk-averse nor extraordinarily aggressive. He then calculated what an optimal portfolio would look like when stable value is available to the investor, using two different methodologies: first, using historical return rates for bonds, and then using current yields as proxies for expected future returns. The latter approach addresses the problem cited earlier—the extraordinary bull market in interest rates since 1990.
Using only historical rates of return for a strongly risk-averse investor, Babbel demonstrated that an optimal portfolio would have allocated about 50 percent of its assets to stable value from 1993 through 2004, and about 25 percent from 2004 through 2015. Plugging in forecasted rates of return using current yields as proxies, however, produced portfolios that allocated about 80 percent of all assets to stable value for much of the time, and, except for one quarter, never less than 50 percent. Optimal portfolios for someone with a very strong aversion toward risk were even more heavily dominated by stable value, with the asset class almost never accounting for less than 80 percent of all assets. Babbel called these findings surprising.
“You guys have a good product,” Babbel told his audience. “This is for Joe Consumer. This is not for the people who play the market; this is for the rest of us.”
Recognizing that some people might argue that equity returns had been skewed over the past 10 years by the catastrophic bear market of 2007-2009 and subsequent recovery, Babbel also created optimal portfolios for each quarter of 2015 in which returns for stocks would be calculated by adding an equity premium to the 3-month Treasury bill yield. Returns for small stocks would be based on those figures plus the historical average spread between small and large stocks over the 80 quarters prior to the optimization quarter.
Here again, Babbel said, he was surprised by his findings. For an investor with strong risk aversion, stable value accounted for just over 80 percent of an optimal portfolio using an equity premium of 3 percent. The balance of the portfolio was roughly split between small-company stocks and long-term corporate bonds. With an equity premium of 5 percent, the allocation did not change much, and even with an equity premium of 7 percent, stable value still accounted for about 70 percent of the optimal portfolio for each quarter, or slightly more. Small stocks, long-term corporate bonds, and long-term government bonds, in much smaller proportions, rounded out the portfolios.
“What’s missing?” Babbel asked. “Large-company stocks. No S&P 500.”
Finally, Babbel conducted one more analysis, again with surprising results. Starting with a hypothetical $10,000 balance, he compared its real, inflation-adjusted value with the inflation-adjusted value of a stable value portfolio for every five-year period beginning with the second quarter of 1973—the first year for which he had stable value return data—through the fourth quarter of 2015. He also looked at those returns for every 10-year period, every 15-year period, and so on, up to 30-year periods. His finding, he said, was that stable value was a good inflation hedge. The real value of a cash portfolio gradually declined throughout the 30 years in every time period studied. The real value of the stable value portfolio declined very slightly in a few of the five-year rolling periods, but generally outpaced inflation. This was even more pronounced over 10-year periods. It increased in value for every longer period analyzed. (A similar analysis, conducted for the 20-year period ending with the fourth-quarter of 2015, showed the stable value portfolio increasing in real value in every period analyzed.) In almost all of the holding periods studied, the value of stable value funds surpassed inflation, and usually by a substantial margin.
For anyone looking for a good inflation hedge, Babbel concluded, this analysis amounted to a clear demonstration of stable value’s attractiveness.
Not that he needed any convincing.