2018’s strong and steady asset performance has given way to much higher volatility. It’s a change driven to a large extent by tightening financial conditions.
However, it’s also a shift likely to moderate over the next six months, which could mean a more positive environment for risky assets in the second half of the year.
In the meantime, conservative investment options like stable value are once-again “having a moment.”
Two members of Invesco’s Stable Value Team, Jennifer Gilmore and George Baumann, answer common questions about stable value funds and what advisors should know when considering the strategy for client portfolios.
Q: Can you describe “stable value” for those not familiar with this strategy?
Baumann: Stable value is an investment strategy that seeks to provide principal preservation similar to money market funds but investment returns in line with intermediate bond funds. It is currently utilized in certain defined contribution plans in the U.S. like 401ks and selected education savings programs like 529 plans.
The strategy combines an actively managed total return fixed income portfolio with contracts issued by insurance companies or banks (commonly referred to as “wrap contracts”). These contracts allow the fund to smooth gains and losses of the underlying fixed income portfolio and ensure an investment return floor of 0.00%, under normal plan circumstances.
Through this combination, the strategy seeks to achieve higher returns compared to money market funds while experiencing lower return volatility compared to traditional fixed income portfolios.
Q: What are the important things to think about when employing this strategy?
Gilmore: We focus on the factors that impact our ability to achieve three main objectives: preservation of principal, liquidity for investor withdrawals and attractive yields that track the path of market interest rates. To ensure that portfolios deliver on these objectives, be mindful of the following considerations:
- Investment strategy — The goal is to build portfolios that balance principal preservation and liquidity needs with an attractive return to investors. This can be accomplished by focusing on high-quality investments, while allowing fixed income managers to diversify investments across fixed income sectors and the investment grade spectrum to add value for investors.
- Plan design and investor characteristics — For stable value portfolios, cash flows into and out of the fund can impact returns. Because of this, it is important to understand how each plan is designed and characteristics of the underlying investors as these items will impact the cash flow experience of the fund.
- Contract terms — Contract terms should be designed to minimize risk to investors. There should be consistency of terms across contracts, and they should incorporate provisions that plan sponsors can understand and monitor.
Q: In your opinion, what are the main tenets of the investment process?
Gilmore: There are four:
- Diversification — Due to the focus on principal preservation, build in multiple levels of diversification including sector, issuer, security and credit quality. Offer diversification at the fixed income manager level through relationships with a universe of fixed income “subadvisors” that employ multiple investment management styles.
- Balanced risk — Recognize that stable value investments play a unique role in defined contribution plans where participants seek principal preservation, but are also looking for additional yield as they work towards their retirement goals. Balance these objectives by carefully constructing investment guidelines that allow for a range of fixed income investments that offer attractive yields while ensuring principal preservation.
- Customization — It’s rare to run across two defined contribution plans with the same demographics, plan design and plan sponsor preferences, so design systems and take an investment management approach that embraces customization. For example, if a plan sponsor prefers a specific group of subadvisors in their stable value portfolio, provide transparent reporting on underlying fixed-income holdings and monitor compliance on a daily basis, thereby meeting their customization needs without sacrificing transparency and risk control.
- Active management — Active management allows for quick portfolio adjustments to reduce risk or enhance returns in response to changing market conditions, plan sponsor preferences or evolving plan or investor characteristics. One solution is to use a “building block” methodology, meaning segment the portfolio into short duration, intermediate duration and core strategies. Each strategy is managed to a unique fixed income benchmark, defining a duration target and sector allocation. This strategy provides liquidity, diversification and flexibility to adjust the strategy and duration target by reallocating between the segments or by adjusting the fixed income benchmark.
Q: How do you see stable value evolving in the future?
Gilmore: Stable value has evolved over the years and, going forward, I foresee further developments:
- Meeting the needs of savings plans — Recent trends in the industry include target-date options and lifetime income solutions. Stable value can be a valuable component, while still meeting the liquidity and unique needs of these options.
- Underlying investments — There needs to be ongoing evaluation of new options for underlying investments that offer advantageous yield, liquidity or performance benefits. As new investment products come to the market and risk tolerance evolves, we would expect to see some evolution in underlying fixed income portfolios, as long as they meet the principal preservation objective and are within client investment guidelines.
- New markets — Even within some defined contribution plans such as 403(b) plans, we do not see the level of diversification and transparency that plan sponsors seek. In addition, there are markets such as Health Savings Accounts (HSAs) where stable value is not offered. It’s entirely possible to create innovative solutions that expand the scope for the use of stable value so that more investors are able to experience its principal preservation and investment return benefits.