Mutual Funds for the Utterly Confused

As we continue or discussion about risk, we look at what was supposed to be one the risk-free - well almost risk free - types of investments, many of you will find in your company sponsored retirement plans. Promising good returns with minimal risk, stable value funds, with their conservative approach have found their way into many participants strategy of saving for the future. Many of them did not know what they we getting into when they thought stable meant safe and conservative.

Kelli Hueler, CEO of Hueler Analytics suggest in a n article written before the market melted down so completely las year that “it’s not just money-market funds that are being scrutinized. Many 401(k) plan participants and employers are fretting about stable-value funds. These products, which are generally available only in defined contribution and 529 plans, typically invest in high-quality bonds and bank or insurance-company contracts that guarantee the value of the principal and offer relatively high interest rates compared with money-market funds.”

This is a vastly different approach than the similarly named value fund offers. While the later invests in common stocks of beaten down or under-valued businesses in the hopes that they will recover, stable value funds invests in investment contracts, certain types of fixed income securities (e.g., U.S. treasury bonds, corporate bonds, mortgage-backed securities, bond funds), and money market investments.

She continues by pointing out that well-known names such as the “troubled insurance giant AIG is a major player in stable-value funds. The company, ” she write, “is a provider of “wrap” contracts that protect the funds against loss of principal. AIG wraps roughly 10% of the stable-value fund assets tracked by Hueler Analytics, a stable value research firm. And that has many investors on edge.”

And with good reason.

Numerous investors, studies have shown, seek safety and not risk in their investments. Stable value funds play to these fears of investor loss and promise returns that are higher than typical bond funds. The assurance of safety however is only as good as the financial institution that issues the fund. And many of these institutions are insurance companies.

Held outside a retirement portfolio, these types of fund offer liquidity, somewhat similar to money market accounts. This type of liquidity was favored by the 529 plan investor who sought to keep the money put away for the child’s college education as a safe as possible. Some folks use them to save for homes while others, simply keep them as risk adverse investments. What these conservative investors sought was safety. What they found was something quite different.

Running from risk doesn’t eliminate it. Stable value funds may not be exposed to the market, and your investment might be safe in principle, but lower interest rates generally tend to drag down the returns many investors expect.

The industry continues to stress the safety of these funds. The assets are actually owned by the 401(k) plan and insured by banks and insurance companies through the use of wrap contracts. Seldom is one wrap contract in place keeping the creditors of defaulted insurer from tapping the stable value fund’s assets.

The inability to make good on obligations such as interest payments puts the fund in line as a creditor. Some of the principal may be recovered but the risk of loss like this is rare in money market funds and much better defined in a bond fund. Long-term investors might suffer from a negative gain in these types of funds as inflation trudges forward but the returns lag behind.

Predictability has its price however. Too much of your portfolio in these types of funds, safe as they may seem, will negate the returns a recovery could have had in your portfolio.