Equity was still king in 1998 when Deutsche Asset Management launched PreservationPlus Income Fund (DBPIX), the first stable value mutual fund targeting [and restricted to] individuals investing in retirement accounts such as IRAs. (The year before, Deutsche had launched PreservationPlus Fund for use in institutional and employee-directed defined contribution plans.) While creation of PreservationPlus Income was a good idea, the economic climate hardly made it an instant success. “We knew that we’d have to build a track record and establish ourselves,” says Eric Kirsch, managing director of North America Active Fixed Income Strategies and head of Deutsche Asset Management’s Stable Value Fixed Income Group. “And we’d have to educate financial advisors, who only maybe knew about stable value from the 1980s, and show them this is a totally different construction than the old GIC [guaranteed investment contract] world.”
Apparently, word’s gotten out. The fund, which blends the best components of money market funds and intermediate-term bond funds, has made waves recently, thanks to five-star ratings from Standard & Poor’s and Morningstar for the fund’s overall and three-year performance. As of January 31, 2002, the fund’s 3-year annualized total return of 6.29% placed it in the top 4% of funds in Morningstar’s ultra-short bond category (more on this later). For the same 3-year period, S&P shows the fund posting an average annualized total return of 6.1%, compared with a total return of 5.3% for all S&P’s Intermediate-Term High Quality funds (more on this, too); the fund rated 78 out of 463 funds in this peer group. PreservationPlus Income records net assets (as of March 1, 2002) of $30.1 million, up from $25.8 million on December 31, 2001.
The fund is run by a large team. “The people who manage this have years of experience,” Kirsch explains. “It’s not like a new asset class that we just developed; we just put it into a new vehicle.” At the helm as senior portfolio manager is Kirsch, a chartered financial analyst who came to Deutsche Asset Management in 1980. In addition to his duties as chief investment officer of Deutsche’s Stable Value and U.S. Fixed Income Index portfolios (with over $40 billion in assets), he currently serves as chairman of the Washington, D.C.-based Stable Value Investment Association board, an education and resource organization founded in 1990, following the early 1980s emergence of the stable value concept itself. He is joined by fund managers John Axtell, managing director and head of the Stable Value Investments Group; and Louis D’Arienzo, director and portfolio manager within the firm’s Structured Fixed Income Group. Lending her expertise to the team is Donna Marsella, a director and investment specialist for stable value and index products. Behind the scenes are numerous sector managers and research analysts providing fund management support.
We recently spoke in New York with Kirsch about his fund’s success and future prospects–and why financial advisors should care to hear about it.
Morningstar has you classified as an ultra-short fund. S&P considers the fund intermediate-term. Which is correct? I think intermediate-term would be the more accurate one.
Why the discrepancy? It’s not a black-and-white answer. If you think about the stable-value portfolio, it has two components. One component is a bond portfolio. Just think of it as a normal investment-grade type of bond portfolio, and that typically has a duration of intermediate to long. In our particular case, we typically keep the duration at about three and one-half years. That’s more of an intermediate type bond portfolio. But the other part of our stable-value strategy is what is called wrapper agreements, which are sort of guarantees and preserve the NAV [per share] at $10. So even though the bond portfolio fluctuates in value as any bond portfolio would, with the presence of the wrapper agreements, which are assets of the fund, the shareholders are guaranteed that when they withdraw their money, the fund’s NAV will be $10. From the standpoint of investors, their principal stays constant, doesn’t fluctuate, they earn a nice rate of income.
You put those two things together and you have a product that really is in the short-to-money-market area of the curve. It acts like a short-duration money market-type product because the NAV stays constant. But the yield that we earn is typically a lot higher than a money market or short-duration bond fund. It’s commensurate with the yield that you’d expect from an intermediate-duration bond fund.
If you look at the product in its totality, the reason I think Morningstar puts it in the ultra-short category is [that] the volatility of the fund is nil. It’s basically that of a money market fund. If you look at it just on the bond piece and you sort of forget the wrappers for the moment, it’s more of an intermediate-duration bond fund. So, it’s not a black-and-white answer. If you look at the pieces, it’s a little bit of both. I can see in the infancy of these products as they are growing, each of those firms– Morningstar, S&P, or even Lipper, for that matter–taking a slightly different view as to where the fund should be.
Classifications aside, the product is best for what type of investor? It is a great alternative for those investors who want conservatism, who aren’t interested in price movements of their bonds, and want a high rate of income with certainty of their principal. Typically they’re looking at money market funds, CDs, maybe an ultra-short bond fund. This is where this product comes out in that category. For investors who really are more than income-oriented, meaning they don’t mind putting money in a bond fund because if interest rates go down, they’ll get capital appreciation–well, they probably wouldn’t use our product because they aren’t going to get that. When interest rates go down, you don’t see the NAV go up. You just see the yield change.
Hordes of baby boomers are retiring. The market is down. And current thought has it that the equity risk premium of 5% is probably half that, which by itself would seemingly prompt advisors to change their allocation strategies somewhat–toward bonds. Are all these valid factors for stable value funds’ sudden popularity? Are there significant others? All of those are definitely factors. Go back to the early ’80s, before Americans became investors, when we were savers, and back to 401(k) plans, which is where stable value grew up. [Stable value] was the product of choice for the 401(k) participants. They wanted safety, predictability, and a good interest rate, because they were saving their money, as opposed to investing it. In the early ’90s, as the market educated participants about their retirement and investing for the long term, and appropriately so, the same savers became investors and changed their asset allocations so they’d have equity in their portfolio.
During the rest of the ’90s, stable value continued to play an important role in saving plans, but attention moved to equity markets. Having said this, we’ve always thought stable value has a place, because you have retirees, people who are older who have a higher allocation to bonds or money markets. Therefore, stable value is a very worthwhile alternative when you look at the risk and the return of stable value, whether you look at it versus money markets or bonds.
How should advisors approach your product? Forget stable value for a moment. At a minimum, given the downward bias you noted in regard to the equity risk premium, advisors are going to do some reallocation, with a heavier weight to bonds. Stable value has the returns of bonds over the long term; we earn the same return as bonds because we are a bond fund. But in the short term, we don’t have the volatility of a bond fund. Let’s define those volatility numbers as standard deviation. I think the average annual standard deviation, say, of the Lehman Aggregate [Lehman Brothers Aggregate Bond Index] is something like five and change. The annualized standard deviation of a stable value portfolio is about 0.08, that of a money market fund. Now let’s use that information and put it into an asset allocation model which, for argument’s sake, gives us a model of 60% stocks and 40% bonds, providing you [with] some result of expected return and expected risk. You could take the bonds out and put in a stable value fund. You could actually keep the same weightings, 60-40, but you would lower your overall risk and keep the expected portfolio return the same, because our standard deviation is lower.
Alternatively, an advisor may wish to increase the expected return of the portfolio. They can make a higher allocation to equity, lower their allocation to bonds, if they use stable value, and end up with that result without any more risk. So as the financial advisors–especially now that stable value is available through mutual funds–plug those historical risk and return numbers of stable value into their models versus bonds, they can end up with a better portfolio solution, depending on what their client wants. If the clients want the returns the same, they would lower their risk by putting stable value in [the portfolio] in place of bonds; or if they want to try to increase the returns, they can keep the allocation–and the risk–the same.
Let’s talk about fund composition. S&P shows you with 15.5% in U.S. government agency debt, and 36.8% in AAA rated, then way down to 2.8% in AA, and back up to 24.6% in single A. What’s the rationale here? From an investment standpoint with the stable value fund, we basically have an emphasis toward spread products. As you look at the bond market, and you look at a benchmark, like the Lehman Aggregate, you have a large percentage of Treasuries in that, with up to 20% allocation to corporates and, I think, currently 45% to mortgages, which is government-agency credit quality.
In constructing a stable value fund, because you have the presence of insurance guarantees–the wrapper agreements to preserve the $10 NAV–one of our objectives is to maximize income. The way to do that is to invest in non-Treasury securities, what many people call spread products. Basically we have an emphasis on corporates, mortgages, and things like asset-backed securities. We’ll use some Treasuries and governments, but typically only 10% of the time would we be in those types of assets, because we can enhance income by finding quality throughout the investment grade area of the bond market. A lot of the triple-A and government agency products are things like our asset-backed securities; we tend to stay in the triple-A area. Mortgages tend to be government agency credit quality. Within the corporate area, the greatest value we find is in the single-A name, some double-A and triple-B names as well, where we can find good quality with good credit research and get paid incremental yields. If you stay with triple-A corporates, the spreads are very, very tight, and you don’t find a lot of value in that.
As for holdings, you have at this writing 161. Is that an optimum number? That is a typical amount. A lot of those holdings include different pass-through securities within the mortgage market. So if you took out the mortgage component, you’d probably find us at around 70 to 90, but with mortgages you have lots of different coupons and pass-throughs.
What about sector consistency? We can make changes if we see more value in asset-backeds versus corporates, but we tend to be fairly steady and we prefer to try to find value at the security level.
Greenspan says the economy is coming out of recession. Any repositionings anticipated? While we do not predict interest rates in managing our fixed-income portfolios, if the economy is coming out of recession, historically, interest rates are expected to increase. Our investment style emphasizes high average quality and a bias toward spread assets. As the economic cycle changes, our credit analysis will emphasize high quality issuers that are expected to be stable to improving.
So what else lies down the road? We’re expecting this year to be one when we do see strong growth, now that we have a three-year track record, the Morningstar rating, a presence on platforms such as Schwab and Fidelity, as well as a lot of interaction with the financial advisor community. The first two years were tough, but we had a chance to talk to people. What we are finding this year is that we’re getting calls back from these folks saying, “I remember when you came in here and described that product. Can you go over that again?”