Stable Value a free lunch?
Recent cases of alleged fraud involved investors placing billions of dollars in unregistered products attracted by smooth positive returns. Hedge funds and other unregistered investment vehicles do not have a monopoly on “stable” positive returns. In fact, there exists a class of products known as stable value funds that share similar stable return characteristics and […]
Recent cases of alleged fraud involved investors placing billions of dollars in unregistered products attracted by smooth positive returns. Hedge funds and other unregistered investment vehicles do not have a monopoly on “stable” positive returns. In fact, there exists a class of products known as stable value funds that share similar stable return characteristics and can be found in many retirement plans. Below are some back-of-the-envelope findings we thought worth pointing out regarding stable returns, stable value funds, and why it is high time to remind ourselves that these products should be evaluated with the same rigor as other investment products.
In the February 25, 2009 SEC complaint, Paul Greenwood and Stephen Walsh were charged with defrauding investors of $554 million through WG Trading Hedge Fund (“WG”). WG employed an index arbitrage strategy and charged 1% management fees and 20% performance fees. When we evaluated WG’s monthly return series’ statistical properties, we found them to be very similar to the average money market fund.
Over the past 5- and 10-years WG produced annual returns of only 50bp higher than some money market funds. In addition, the correlation between WG and money market funds is around 90% and for some funds is as high as 98%! Lesson learned: a simple statistical profile, in this case correlation analysis, can provide a useful sanity check before committing millions of dollars to a particular investment strategy.
Robert Stanford’s SIB marketed stable high-yielding CDs to investors as a part of his alleged fraud. Returns were in the 6-10% range ((Over the period 1992-2006. See chart on p.28 of the complaint)) and were significantly higher than CDs offered by commercial banks but very similar to the returns on the investment product that many of us have in our respective 401(k) and IRAs – Stable Value funds (SVF).
Using data provided in the SEC complaint we compared statistical properties of SIB returns paid to investors with a large group of stable value products and found them to be almost identical (based on 15 annual return numbers) both in risk and return. Moreover, the correlation of some of these funds to Stanford was as high as 94%.
In all recent cases of alleged fraud including Madoff, Stanford and WG Trading, investors were looking for stable positive returns and were willing to take risks and invest in investment products with no protection and no transparency. Stable Value funds, while providing very similar smooth positive returns, are legitimate registered products1 but investors have to understand that they carry certain risks. Unlike money market funds, SVF invest in longer-term high grade bonds and, therefore, are exposed to interest rate and credit risk. At the same time, these risks are not visible to investors because SVF are priced at book value rather than market value which allows them to report such stable positive returns. Principal and accrued interest are guaranteed by a number of insurance-wrapper contracts with multiple insurers AIG included. As of today, almost 20% of all DC assets or over $400B is invested in SVF.
There are several links below that go into more detail on the risks of SVF and the call for more fiduciary rigor in their assessment.
David Merkel’s Blog
A very good insight into structure and risks of stable value products from an industry insider where he’s pointing to interest-rate, credit and asset default risks.
Stable Value Investment Association
Describes challenges facing these funds in the current market environment. In short, investors should request better transparency, especially on MV/BV ratio and wrapper agreement terms.
J.P.Morgan Insight > Retirement Plans
Examines the procedures plan fiduciaries use in evaluating their stable value fund options. Has a fund performed well if the stabilized returns are positive and stable? You can only assume. No plan sponsor can clearly determine what risks were taken and whether the manager’s returns reflect a prudent tradeoff of risks and rewards by simply looking at the book value returns.
Footnotes
- 1With an important caveat: stable value funds are registered with DOL, not SEC.