Stable Value Funds: Performance to Date – Part I

Stable Value Investment Funds (SVIF) are offered in almost half of all defined contribution (DC) plans in the USA, with more than $800 billion dollars worth of assets under management. Historically, they have been one of the two most popular asset classes for people enrolled in such plans.

Unlike stocks, bonds, and many other asset classes, they are generally not susceptible to large fluctuations in value, but accrue attractive interest over time while providing necessary liquidity at book value. Therefore, they may be especially suitable as people approach retirement and are also useful after retirement.

Their stable value allows a person to transition into retirement without any late-inning unwelcome market surprises that can devastate a retirement plan. After retirement, for those plans that allow participants to retain a portion of their assets in SVIF, the availability of funds at book value is important when extraordinary expenses are incurred. 

In three related studies[1] conducted over the past seven years, we have examined SVIF performance relative to six other major asset classes, including U.S. large stocks, small stocks, long-term government bonds, corporate bonds, intermediate-term government and corporate bonds, and money market funds.

Our evidence suggests that going back to their inception in 1973, SVIF have dominated two (and nearly three) major asset classes based on a historical analysis and that they often occupy a significant position in optimal portfolios across a broad range of risk aversion levels.

We discuss the factors that contributed to stable value’s remarkable performance and whether it can continue to maintain it into the future. Our various studies used three methods to examine historical performance:

• Mean-variance analysis
• Stochastic dominance analysis
• An enhanced multi-period utility analysis

In Part I of this report, we will briefly discuss the mean-variance results. Part II will summarize the performance results using the other methods.

What are Stable Value funds?

SVIF offer principal protection and liquidity to individual investors, and steady returns that are competitive with intermediate-term bond yields. However, over ensuing one-to-three-month intervals, the guaranteed rate of return moves much more slowly than intermediate-term bond yields.

This is achieved by having a process that allows the provider to smooth market volatility through amortizing gains and losses over the duration of the portfolio. This smoothing is effected through the rate re-set mechanism and insulates against day-to-day volatility. Consequently, SVIF provide investors with positive returns of very low volatility. This combi­nation of bond-yield-like returns and low volatility generates contract or book value ac­counting of the investment.

The underlying investment portfolios of SVIF are comprised of high quality, short maturity corporate and government bonds, mortgage-backed securities, and asset-backed securities. In all but a few pre-specified circumstances, investors in SVIF are able to transact (make deposits, withdrawals, transfers) at book or contract value, which is deposits plus accrued interest, less any past withdrawals.

While SVIF do not require a set holding period but provide full access to the par­ticipant’s principal and accumulated interest, they are sub­ject to the general restrictions within the overall plan. For example, many plans restrict participants from the direct transfer to a competing short-duration bond or money market fund by requiring that money transferred out of SV be first invested in a non-competing (e.g., stock or long-term bond) fund for a short period such as 30-90 days to eliminate arbitrage.

This rule, together with the fact that plan participants do not act in concert re­garding the allocation of their funds, allows the investment contract protections to be provided for a fraction of what it would cost if interest arbitrageurs domi­nated the pool and were revising their allocations aggressively.

Mean-variance analysis

From an investor’s viewpoint, SV funds operate like a passbook savings account. They accrue interest at a pre-specified crediting rate that is generally updated every one to three months to slowly incorporate changing market conditions. Below are compared the relative yields of stable value and money market funds in the stressful post-crash period.

SVIF also fared well over a longer time period. The SVIF returns shown are net of all fees. Note that over the twenty-one-year period shown below, there were only two brief intervals lasting a month or two each when the money market fund average yield exceeded the stable value average.

Despite shortcomings, the mean-variance approach is a popular analytical tool and provides useful in­sights into the ability of SV investments to dominate other asset classes.

The historical record provides evidence that, even as stand-alone investment, SV funds have been superior in the mean-variance sense to money market and intermediate-term government/credit bond funds.

Based solely on historical returns, when included in optimal mean-variance portfolios, SV funds contribute significantly to the portfolio, to the exclusion of money market, intermediate-term government/credit bonds, long-term corporate bonds and even large stocks.

In other words, optimal mean-variance portfolios based on past data contain only SV funds, long-term government bonds and small stocks in proportions that naturally vary with the expected return (or, alternatively, the expected volatility) of the optimal portfolio.

(Looking forward, we would expect long-term government bonds to be excluded from the set of efficient portfolios because their historical returns benefitted from a significant drop in yields, producing huge capital gains. We cannot expect such a significant drop in yields going forward, so their future returns relative to other investment classes cannot benefit from the capital gains.)

For example, over the past 23 years, from January 1989 through January 2012, SV returns exhibited both a higher mean and lower volatility than either money market or intermediate-term government/credit bond returns. This feature can be seen in the figure below, where we plot two efficient frontiers, one including all seven asset classes in our study and one that excludes the value-weighted SV (VW-SV) funds. The plot extending back to 1973 looks about the same.

While not shown here due to space constraints, we observed that no optimal mean-variance portfolio along the efficient frontier included money market instruments, intermediate-term bonds or long-term corporate bonds. Not even large US stocks were included. We also observed that SV funds predominated in the lower portion of the expected return range, where one would conventionally anticipate seeing money market and intermediate-term bond investments.

The Sharpe ratio, com­monly used in performance measurement, meas­ures excess return per unit of risk. It measures how well an investor is compensated per unit of risk taken. Higher ratios denote greater return for the same level of risk.

The Sortino ratio focuses more on the downside risk. It is based on the Sharpe ratio, but penalizes for only those returns that fall below the target return, which in our case is the average riskless rate of return over the period of analysis. It gives the actual rate of return in excess of the risk-free rate per unit of downside risk.

The Sharpe and Sortino ratios for quarterly net return data from 1989-2011 are reported in the table below.