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The bull market in stability

In this grinding bear market, conservative investment options have taken on a new sheen. A case in point: the newfound popularity of stable-value funds.

In this grinding bear market, conservative investment options have taken on a new sheen. A case in point: the newfound popularity of stable-value funds.

Long a mainstay of the 401(k) market, these funds are starting to appeal to retail investors, who are putting them into their individual retirement accounts. Stable-value funds represented 11 percent of the $1.6 trillion in U.S. defined-contribution-plan assets in 2001, according to consulting firm Cerulli Associates. Assets invested in the eight stable-value IRA mutual funds tracked by the Stable Value Investment Association, a Washington, D.C., trade organization, have jumped dramatically this year, from $1.3 billion as of December 31, 2001, to $2.9 billion as of September 30.

Why the shift into the mutual fund market? For much of the 1990s, "there was so much growth in the defined contribution market that vendors simply focused on that," says Laura Dagan, COO of Burlington, Vermont­based Dwight Asset Management Co., which manages Pilgrim Baxter & Associates' PBHG IRA Capital Preservation Fund. But as total defined-contribution-plan assets have fallen along with the stock market, fund managers have been looking for new growth areas. The IRAs of retail investors seem to be the most promising.

Essentially, stable-value funds are insured fixed-income portfolios. They invest in high-quality short-to-intermediate-term bonds (typically, less than five years) and guaranteed investment contracts, as opposed to the very short-term securities found in money market funds. To mitigate volatility, stable-value funds then buy insurance "wrappers." These instruments, which are contracts with major insurers or banks, are used to maintain a stable net asset value. Generally, the arrangement works like this: If, for example, the fund's NAV falls from $10 per share to $9, the wrapper will pay the $1 difference to maintain the $10 NAV. Unlike a money market fund, however, it's not an ironclad guarantee. If interest rates suddenly spike or the insurance company defaults, the fund's NAV will fluctuate.

Because their portfolios include some intermediate-term bonds, stable-value funds have been producing a higher yield than their money market counterparts. This year they are yielding between 2 percent and 3 percent, while most money market funds are yielding less than 2 percent, according to Morningstar analyst Brian Portnoy.

Stable-value funds are the offspring of guaranteed investment contracts, the investment vehicles that were wildly popular until two big insurers ran into trouble in the early 1990s. Executive Life Insurance Co. and Mutual Benefit Life Insurance Co. made bad investments in junk bonds and were unable to repay GIC investors for years after the junk market tanked in 1989. Today's stable-value funds for the most part avoid high-yield debt, though the Scudder Preservation Plus Income Fund does have some money in the asset class.

As baby boomers begin to retire --the eldest of the generation turn 56 this year -- stable-value providers are now paying close attention to the rollover IRA market. Of course, investors in their 50s who are nearing retirement are more interested in stability and capital preservation, which makes them prime customers for stable-value funds. "There's tremendous growth projected in the rollover IRA market," says Dwight Asset Management's Dagan.

Adds Sarah Friedell, a spokeswoman for Fidelity Investments: "Many investors have become familiar with stable-value products through their retirement plans. As more investors move toward retirement age, they are going to move toward more fixed-income products."

To get at that growing potential market, Fidelity will roll out its Fidelity Stable Value Fund in December. Fidelity joins Deutsche Asset Management's Scudder Investments, Gartmore Global Investments, Oppenheimer Funds, Pilgrim Baxter and Principal Financial Group, among others, in offering the product.

Stable-value funds are not cheap, notes Morningstar's Portnoy. "They often yield more than money market funds, but their high costs seriously dim their appeal," he wrote in a recent report. The use of the insurance wrapper also pushes up costs. Portnoy says that the average short-term bond fund costs 82 basis points annually, and most money market funds are cheaper than that. Contrast that with the price tag for a stable-value fund, which can run well over 100 basis points.

For example, Oppenheimer Fund's Oppenheimer Capital Preservation A costs 1.59 percent annually. Toss in redemption fees, which are typically 2 percent of assets, and the costs swell further. "Expenses erode their potential advantage over most bond funds," Portnoy writes.

From Dagan's perspective, though, redemption fees serve a purpose that benefits all fund investors: They deter market timers who suddenly shift large positions in and out of a portfolio. "We're a core holding," she says. "We don't want hot money."

As for expense ratios, Dagan insists that many stable-value products are cost-effective investments. "Our expense ratio is capped at 100 basis points," she says. "Today money market funds are yielding 1.25 to 1.5 percent. Net of fees, our 30-day yield is 4.5 percent. That's real money."


Don't look back

Everyone knows the disclaimer: Past performance is no guarantee of future success. That's one reason Chicago-based Ennis Knupp + Associates, which advises 117 institutional clients with assets totaling $386 billion, decided to introduce a new scoring system for hiring and firing money managers that deemphasizes historic returns.

"I'd say 80 or 90 percent of a plan sponsor's decision-making process winds up being driven by the numbers," explains Richard Ennis, co-creator of the new EnnisKnupp Expert System. "It shouldn't be that way, we know, but it is. If there is one thing I've learned in 20 years of doing this, it's that past performance does not help you measure a manager's future potential. The time had come to formally take past performance out of the driver's seat."

Ennis is also unusual in publishing the details of his system. Evaluating eight main factors -- perceived skill, trading ability, fees, past performance, product fit, product's importance to manager, ownership and other organizational considerations -- the system grades a manager on a 20-point scale, with higher scores being better. In reviewing perceived skill, for example, Ennis Knupp examines five subfactors -- cogent investment thesis, information advantage, unusual insight, talent and sound investment process -- and then awards the manager a numerical score. The maximum total for perceived skill would be four points, or 20 percent of the potential grand tally. Past performance counts for a maximum of three points, or just 15 percent of the 20-point total. The system even has a built-in "gut-level" adjustment of plus or minus two that offers the sponsor the chance to inject its own subjective judgment.

Toting up the numbers gives the manager a rating, in much the same way magazine quizzes offer readers a chance to rank some aspect of their personal lives. A score ranging from 16 to 20 can win a firm a slot in the final round of a manager selection contest, whereas a weak 0 to 7 rating merits a "Do not hire/Terminate if employed" advisory.

Ennis contends that the system has worked well since it was released in the spring and has helped sponsors detect hidden weaknesses of managers with strong performance numbers. Most often these days, he says, it gives plans an argument for retaining a favored manager whose numbers haven't been good.

"You do wind up with situations where managers with seemingly poor performance can draw a good rating," Ennis says. For example, Ennis Knupp recently put Wellington Management Co., which has fallen short of its U.S. equity benchmarks by several percentage points in the past year, through its system. Wellington scored well in seven of eight categories, the exception being performance. Wellington thus received an overall rating of 16, or the bottom of the top category. "Using the system, our position on Wellington is unchanged: Hire/Retain," says Ennis.

John Krimmel, CIO of the $9.9 billion State Universities Retirement System of Illinois, says the fund has run beta tests of the Ennis Knupp system, most recently while conducting a global equity search. Two firms, Capital Guardian Trust Co. and Wellington, were hired out of a field of a dozen leading candidates. "It has served us well," Krimmel says. "You get a thorough evaluation of what the manager brings to the table. Performance is important, but it's downplayed."

Frank Russell Co. has been scoring managers for decades, and most other consultants maintain their own proprietary evaluation methodology. "It's admirable that Ennis Knupp is putting a manager's past performance in the proper perspective, because too often plans hire at the top and ride managers down," says Jennifer Cooper, founder of Cooper Consultants, which evaluates investment consultants on behalf of plan sponsors.

Still, Cooper contends "this system doesn't break new ground" in its meth-odology. Ennis doesn't agree: "There are lots of examples of expert systems in other industries -- in baseball scouts use one to evaluate recruits -- but I haven't seen anything like it in money management." --Rich Blake