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In Defense of Stable-Value Funds

A look at the issues surrounding this embattled fund category.

Anyone who witnessed the perils of some of the "great" fund innovations of the 1980s and 1990s can understand a desire to scrutinize such strategies before they blow up. From option-income funds to short-term global offerings to derivative-laden mortgage portfolios, the fund world has unfortunately offered several innovations that worked much better on paper than in practice.

Against that backdrop it might seem reasonable to take an ax to stable-value mutual funds, which mix bond portfolios with so-called "insurance wrapper" contracts to shield investors from losses. By holding notes and bonds, rather than ultrasafe money-market-style investments, stable-value managers can pump out lots of income, while a cocoon of insurance wrappers helps keep a lid on volatility

Useful, but Imperfect
Naturally, anything with so much complexity and such a good story is bound to attract scrutiny. And to be sure, we at Morningstar have looked at stable-value funds pretty critically in the past. All of the available stable-value mutual funds charge a pretty penny for their services, which takes a big bite out of the income payouts they produce. And though stable-value management has been around a lot longer in the institutional market, the lack of detail provided in most funds' prospectuses has always been a sore point for us. One can learn about the costs and general idea behind the insurance wrappers used in stable-value funds, but there are a lot of details that usually go unexplained. So while we've known that money has been managed this way for years on behalf of institutions and retirement plans, and apparently without incident, we've always hoped for better disclosure from mutual funds so that investors could better size up the design and risks of the available options.

The recent demonstrated interest of the Securities and Exchange Commission in stable-value mutual funds therefore initially struck us as a positive. The more involved the SEC gets in this arcane corner of the market, the more likely one would expect standardization of practices and disclosures to be. Moreover, rumors in the industry, which were later confirmed by a Wall Street Journal article, suggested that big players such as Fidelity were looking to get into the business of running stable-value mutual funds. We've long hoped for such "big-name" involvement because it tends to have the effect of setting an example for competitors to follow. In other words, if Fidelity (as just one example) were to have a well-run stable-value fund attracting investor attention, the standards--and perhaps even the costs--it employed might become a model that rivals would have to address in order to stay competitive.

A Potentially Capital Case
It appears, however, that the unusual nature of the wrapper agreements has troubled the SEC enough that it might eventually decide to ban the stable-value strategy for use in mutual funds. Apparently as a result of signals from the SEC (though nothing has yet been declared publicly) a couple of fund managers have already elected to wind down their stable-value fund operations, while another just announced that it would no longer accept new investments. Others, such as Fidelity, have shelved plans to roll out new funds. The crux of the problem appears to be concern that the aforementioned insurance wrappers aren't easily valued on a day-to-day basis, which makes coming up with a reliable net asset value a tricky proposition.

There's no question that without tight oversight and high standards of practice, mutual funds with assets that can't be easily priced on a daily basis represent a vexing problem. After all, daily redemptions and purchases rely completely on fair and accurate pricing. On the other hand, stable-value funds aren't the first to present such dilemmas. Numerous funds in other sectors struggle with pricing issues that arise from difficulty in getting daily trading information, yet the SEC has found ways to monitor and guide them.

Can This Mousetrap Be Rebuilt?
Rather than declare an outright ban on stable-value mutual funds, we'd love to see the SEC implement more stringent rules within which the funds would have to operate, so as to help ensure that the unusual nature of their wrappers doesn't present undue risk. In effect, that's what was done several years ago when rule 2a-7 was established, so that companies could run money market funds with stable net asset values of $1 per share. In other words, in order to be called money markets, funds must follow strict rules that govern accounting as well as portfolio quality and maturity. Those rules don't guarantee that investors won't lose money, but they do represent a regulatory threshold that money market funds must surpass, in exchange for the freedom to operate outside of the daily valuation rules that normal mutual funds must observe.

Just what kind of new rules might make sense? Minimum requirements for the source, structure, and number of wrapper agreements could be a good start. And though we've always known about their use, fund companies generally don't disclose how many wrappers are in place at a given time, nor which companies are providing them. It would also be ideal if fund companies were required to explain in some detail just how they and their wrapper providers are working together to protect the portfolio. It probably wouldn't be necessary to give every detail on the complex calculations that are made, but a clear explanation of their mechanics would help investors understand just how they're supposed to work.

Although a portfolio's underlying credit quality and interest-rate risk might seem more appropriately left to fund managers, it would probably make sense for the SEC to set some limits on just how much risk a fund could take on while still calling itself a stable-value offering--not unlike the money market model. One reason is that insurance wrappers don't generally cover defaults, so credit quality is important. Alternatively, one can imagine circumstances under which an aggressive portfolio manager might ramp up exposure to long-term interest rates, and take a big enough hit to cause problems for, and with, the fund's wrapper providers. Setting standards for those issues would simultaneously help protect investors and help ensure that excessive risks don't overwhelm the protection that wrappers are intended to provide.

Keeping Investors' Options Open
The bottom line is that although the universe of stable-value funds is currently small and dwindling, it represents an important option for individual investors. There are few other choices that can offer a similar profile of high credit quality, relatively generous income, and price stability. We'd love to see the SEC work out a solution to its concerns that would preserve this option. Otherwise, investors will find themselves cut off from yet another investment strategy that's available to big institutions, but not the little guy.

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