By Randy Myers
There was a time in the stable value industry when the term “competing fund” almost always referred to one thing: a money market fund.
No longer. Over the past decade or so, the financial services industry has rolled out a slew of new investment products for defined contribution plans, from inflation-protected bond funds to target-date funds and self-directed brokerage accounts. Stable value issuers—particularly stable value wrap issuers—have had to think carefully about how plan participants might use these new products during periods of rising interest rates, and whether they should be classified as competing funds subject to the same trading restrictions typically imposed on money market funds.
Those restrictions are aimed, of course, at discouraging plan participants from trying to arbitrage stable value funds and competing funds when interest rates are rising sharply. The most common restriction is an equity wash rule that requires money moving from a stable value fund to a competing fund to first go into an equity fund for a fixed period of time—usually 90 days.
During a panel discussion at the 2013 SVIA Spring Seminar, executives from four firms—two portfolio managers and two wrap issuers—talked about how their definition of competing funds has evolved, how it continues to evolve, and how the industry can make competing-fund restrictions less objectionable to plan sponsors.
Anthony Luna, vice president and portfolio manager for T. Rowe Price Associates, said his firm generally defines competing funds as fixed-income products with a duration of three years or less. However, he noted, some wrap providers also put certain asset-allocation products under the competing-fund umbrella. These can include target-date funds and balanced funds, but typically only when they have a large allocation to fixed-income assets—perhaps 75 or 80 percent of the portfolio—and when the duration of that part of the portfolio is less than three years. “Most of our contracts also view self-directed brokerage accounts as a competing fund,” he added.
Jennifer Gilmore, head of stable value portfolio management for Invesco Advisors Inc., said her firm’s definition of a competing fund is similar to the one Luna spelled out. She added that self-directed brokerage accounts are the investment option that most often prompts discussions with wrap providers over whether they should be placed in the competing-fund category. “We have to look at the specifics over every plan’s self-directed brokerage window,” she said, explaining that her firm typically allows no more than 25 percent of plan assets to be allocated to that investment option.
Christopher Pellegrino, a portfolio analyst for Transamerica Stable Value Solutions, and Tim Grove, vice president of markets-product risk for Prudential Financial, said their definitions of competing funds are similar to those used by T. Rowe Price and Invesco, too. Grove noted, though, that his firm sometimes classifies Treasury Inflation-Protected Securities, or TIPS, funds as competing funds, too, assuming they have a short duration. Most do not, he conceded, although he said duration is not the only factor his firm considers.
“When we think about TIPS funds, we also think about how it’s communicated to plan participants,” he said. “What does the fact sheet say? How does it describe the fund’s objective? Will it be a safe alternative to stable value, even if there might be some underlying characteristics that could cause fluctuation? How is the participant going to view it? We’ve seen similar funds described differently, and how participants see it can be important.”
Grove also conceded that the stable value industry has not reached a consensus on whether to treat self-directed brokerage windows as competing funds. His firm does. “It’s the access they have to money market funds underneath that’s the issue,” he said.
Gilmore said the arbitrage risk embedded in brokerage windows should be a concern to every plan sponsor as they seek to protect the interests of their plan participants, particularly those invested in stable value. Often, she said, it is the most sophisticated plan participants who are most likely to use brokerage windows and who are, perhaps, most likely to spot and act on arbitrage opportunities. “Overall, plan sponsors understand,” she said. “They just want (any restrictions on the use of competing funds) to be workable. They have to be restrictions their record-keeper can implement, and that they can communicate clearly to participants.”
Luna added that as a stable value manager, it’s easier for him to justify competing-fund restrictions to plan sponsors when those restrictions are workable. “If I don’t believe in what you’re telling me and you’re putting me in front of a client, typically the conversation doesn’t go well,” he said. By way of example, he said it would be difficult for him to defend a request to classify a TIPS fund with a 9-year duration as a competing fund. “Some sponsors are fairly sophisticated investors; they might run their own bond portfolios,” he explained. “When you try to tell them a long-duration TIPS fund is a competing fund, they’re not buying it.”
Gilmore noted that plan sponsors are sensitive to competing-fund restrictions, especially when the fund in question has been in a sponsor’s plan for some time without any restrictions. “Every time a new fund is declared competing, that’s another event requiring the sponsor to go in front of a committee and explain it,” she said. “And they’re making more of these trips, on many different subjects.”
“We can help by being more consistent on definitions of competing funds,” seconded Grove.
Bradie Barr, senior vice president-marketing for Transamerica Stable Value Solutions and moderator of the panel discussion, asked if there were risk mitigation tools that might be more palatable to plan sponsors and plan participants than an equity wash. Gilmore was not sure. “A lot of plan sponsors are used to the equity wash now,” she said. “We did some brainstorming internally and a lot of the alternatives we brought up were more restrictive than an equity wash. We had started thinking about trading restrictions when market value is below book value for stable value funds, or imposing some type of fee for going to a competing option. But I think those just create more complications and concerns. So I do not know that there’s an easy answer to the question.”
“From my perspective as a manager, choice for sponsors is always good, especially for our separate account clients,” Luna offered. He said one option the industry might consider is increasing the cash buffer in a stable value fund in lieu of imposing an equity wash. That would shorten the duration of the underlying portfolio, make additional funds available to meet redemptions if plan participants tried to arbitrage stable value and competing funds, and help protect wrap issuers. It would, in effect, quantify for sponsors the “cost” of an equity wash. “Clients appreciate a quantitative approach and choice,” he said. “It may not be the solution for everybody, and as an investment manager I may not be a big fan of it, but some sponsors may feel it’s more appropriate for their participants.” Assuming a fund had a strong market-value-to-book-value ratio, Luna said, a bigger cash buffer could be a “fairly easy” solution.
Grove was hesitant to endorse the cash buffer solution, saying it might be difficult to come up with an industry standard for how big cash buffers should be. “A good thing about an equity wash is that there is a common understanding and acceptance of it,” he said. And, he added, it effectively provides two protections. First, it forces plan participants to put their money at risk for some period of time—usually 90 days—if they want to engage in interest-rate arbitrage. Second, by the time that period has passed, the arbitrage opportunity may have passed, too.
Pellegrino said one way the industry can minimize controversy over competing-fund restrictions is to work with plan sponsors when they are setting up plans to make sure there are no competing funds in the investment lineup right from the start. “That way, we don’t have to go back and have other conversations after the plan lineup is set up,” he said.
