Bathing in Risk – the 90 Day Equity Wash

We have previously discussed the somewhat unique nature of stable value funds and how stable value fund performance subtly changes over time. Until now we haven’t discussed another aspect of your stable value manager: paranoia.

By their very nature no fund manager wants to see their investors cash out in favor of another fund. They believe in what they do and, additionally, their pay is largely impacted by the amount of assets in the fund. Less is bad.

Stable value managers have taken this very understandable position and expanded upon it: investors currently in a stable value fund aren’t allowed to transfer their assets to a competing fund. Moreover, investors already in a competing fund aren’t allowed to transfer their assets directly into a stable value fund. The only exception to these rather stringent rules is for investors transferring in or out to spend at least 90 days exposed to the risk inherent in the stock market: the “90 day equity wash” provision

We can all understand why fund managers don’t want investors to leave. Most of us are probably more than a little fuzzy on why stable value managers won’t accept money directly from a competing fund. All of us could probably use a little help on why we’re washing anything in equity (laundering generally has negative connotations in the financial world). What are stable value managers so worried about?

The best way to explain their concern is via an example. In this hypothetical 401(k), both a stable value fund and a money market fund (the primary competitor) are offered.

For year-to-date 2009 performance, the stable value fund is outperforming the money market fund by more than 2%. It’s not hard to imagine that investors with the ability to move their assets would cash out all of their money market holdings in favor of the higher rate offered in the stable value fund.

Let’s take this same scenario and project it out a few years. In this hypothetical – but fairly realistic future – the Fed has raised short term interest rates a number of times to fight inflation and money market funds are now paying 5% or more in interest. The bond portfolios of stable value funds will suffer in a rising rate environment and it’s very likely that they will offer a rate of return that is 1 – 2% less than that of their money market peers until the markets stabilize. Investors in this scenario have a large incentive to liquidate all of their stable value assets in favor of the money market fund.

There’s one problem with both of these situations for the stable value managers: cash flow. The single biggest driver for stable value fund performance is cash flow. Huge inflows or outflows of money cause them to buy or sell at problematic prices that will ruin their near and long-term returns. Hence the paranoia on the part of the managers that good times will lure investors to jump on their wagon and those same investors will jump off when money market funds outperform for short periods.

The solution to this quandary is the aforementioned 90-day equity wash. This provision, which only kicks-in when a competing fund such as a money market or short-term bond fund appears in a menu alongside a stable value fund, will not allow direct transfers /exchanges between the competing funds. Participants aren’t allowed to pile on nor are they allowed to all jump off as they can move between competing funds ONLY after the money sits for at least 90 days in a stock fund (or in some cases a much more aggressive bond fund). Investors are still technically free to come and go as long as their movement involves exposing the money to the risks of the market for at least 90 days.

Stable value managers are counting on a little bit of paranoia on the part of their investors as well. They don’t think that investors will take the risk of exposing their “stable” assets to the stock market for 90 days in return for a temporary upside of 1 – 2%.

Confused? Many employers have their own healthy paranoia of this situation too but their fear is based around the prospect of successfully explaining these restrictions to their employees. To alleviate that fear and complication, many employers will offer only a stable value or money market option – not both. If there is no competing option, then there is no need for an equity wash.

The takeaway for investors is that the paranoia on the part of the stable value managers has resulted in real life limitations. You may or may not be type of investor who would jump in and out of their product. They aren’t going to give you a chance to find out.

*Originally published August, 2009.