Stable funds, which are investments that can only be bought and sold through various tax-deferred pensions, gained in popularity when Wall Street fell in 2008. Stable value funds, as a whole, were able to edge out the market and produce an average 4.7% return last year compared to near 40% declines for major market indices. However, one of the many tools that stable funds use to retain their value is now faltering with the world's insurance giants. Heftier premiums and higher hedging costs may leave stable funds at the back of the pack for 2009 returns.
Stable funds operate on a completely different dictionary than most stock and bond funds. A stable fund is designed to do one thing and one thing only: protect wealth against market declines and inflation. However, stable funds do pay a return, known as the crediting rate or the rate of interest that the fund will earn. Generally, stable funds buy into a basket of fixed income securities and then hedge their bets with low cost insurance from larger investment banks. By hedging, the stable fund seeks to maintain its book value, or how much the fund as a whole is worth.
Big Market Movements
Huge movements in stock and bond markets have affected the book value of many stable funds. When the value of bonds drop, so does the value of the portfolio. In this case, the insurance company hedges to prevent the price from actually changing; however, this is not reflected in the portfolio.
Higher Insurance Premiums
As multinational insurance giants are wiped off the map due to a financial crisis, the amount that stable funds are paying to insure their assets has soared. Risk aversion, as well as a limited amount of capital, affects insurance rates and the number of insurance companies that can compete for the policies. Higher insurance premiums eat into the returns that investors are expected to earn, as it is a direct cost of hedging.
Laid Off Employees Aren't Happy with Stable Funds
Stable funds are largely invested in long term debt from treasuries to corporate bonds and other instruments. Because of this, many laid off employees are having a hard time withdrawing their equity from their retirement stable funds because insurance companies and bankers are unwilling to insure or “wrap” their holdings. In this case, banks would have to infuse the fund with cash to make good on withdraws and give banks an equal stake in the holdings of the fund until more money is invested in the fund. In the days of the asset bubble, this business model worked perfectly, as old money was replaced several times over with new money. However, financial hardship in many areas of the country is putting additional strain on the stable fund industry.
It Could Get Even Worse
Stable funds might be 2009’s worst performing funds. With recent gains in the stock market, a bull market rally now could mean stable fund investors miss out on the gains. In addition, record low yields and rates are unlikely to stay around for much longer as bond investors fear inflation. Higher inflation rates pushes down the prices of bonds and the book value of the stable fund. It becomes a lose-lose cycle of losses that can simply not be avoided. The difference in the book and market value of the funds will have to be made up with even greater infusions of capital from banks, insurance companies or from investors, who after seeing the bull run in early 2009, may be weary to lock in money at such low rates.
There are Better Ways to Invest
There are plenty of better, safer and far more liquid investments than stable funds. Though many of those invested in stable funds do not have a choice as it is a part of a pension program, others may find the slightly lower returns in certificates of deposit a fair exchange for greater liquidity should the financial need arise. Though stable 401k funds may have topped the charts in 2008, they're far more likely to make a lackluster performance this year.