Are Stable-Value Funds Really Stable?

(MoneyWatch)  With the market's unpredictable swings, any product with a name like "stable-value funds" is going to sound enticing to most investors. But are they are good investment product for you? While you should take note of the negatives of these products, there are a few instances where these investments may be your best choice.

Stable-value funds seem like good bets in the current environment, given their performance last year. The average stable-value fund returned 4.7 percent last year, while the S&P 500 Index fell 37 percent. These returns are causing a spike in popularity, according to an article in The Wall Street Journal. Stable-value funds held about $520 billion at the end of 2008, up 25 percent from the end of 2007.

However, the Journal article also points out that there are risks showing up in these vehicles. Lower returns on the investments' underlying bonds have caused yields to fall, and banks and insurers who guarantee returns on stable-value funds are growing increasingly wary of insuring these products.

You should be aware of the additional risks of investing in these funds. As I explain in my book The Only Guide to Alternative Investments You'll Ever Need, large sums of money flowing into stable-value funds when interest rates are low causes investors to receive lower returns. That's something we're starting to see. Also, there can be restrictions on withdrawing cash from these funds.

You should also be aware of the opaqueness of the funds' holdings. You may not be able to figure out the quality of the underlying holdings, making it difficult to gauge the risk of your particular stable-value fund.

Overall, however, these funds are a relatively safe option and may be your best bet for fixed income investments in your 401(k) or profit-sharing plan. However, it is always prudent to diversify risk, avoiding the too-many-eggs-in-one-basket problem. One point in their favor is that stable-value funds exhibit low correlation with stocks.

One thing you should do when considering an investment in stable-value funds is to check out the market-to-book ratio. You should be fine if it's at least one. A ratio below one means it is likely that future returns will be lower as the market value of the assets is less than one. And any figure significantly lower than one would indicate that the fund took some significant risks, which have shown up.

Further reading: My MoneyWatch colleague Barbara Bedway wrote an excellent article taking you Inside Stable Value Funds.