Is the Payden/Kravitz Cash Balance Plan Fund a Good Investment Vehicle?

One of our BAM Advisor Services clients requested we look at the Payden/Kravitz Cash Balance Plan Fund (PKCBX). I asked Kevin Grogan, my Right Financial Plan co-author, to provide his thoughts.

The fund is designed to be used by cash balance plans -- a defined benefit retirement plan that maintains hypothetical individual employee accounts like a defined contribution plan. The employees' accounts earn a fixed rate of return that can change from year to year. PKCBX's objective is to outperform the 30-year US Treasury Yield (a common interest crediting rate for cash balance plans). The firm's Web site states the fund targets consistent return and seeks to minimize risk and avoid financial surprises. Let's take a quick look at some of the fund's characteristics and see if this is an accurate picture.

The fund isn't invested 100 percent in fixed income. In fact, it's roughly 10 percent equities and 90 percent fixed income.
The fund has 35 percent invested in high-yield debt instruments, which have equity-like risks. Based on academic research on high-yield debt, we can estimate that this exposure is like another 10 percent exposure to stocks, putting total equity-like exposure at about 20 percent.

Clearly the appropriate benchmark for this fund shouldn't be a 30-year Treasury, as the fund is taking much greater risks. And making matters worse is that the fund has an expense ratio of a whopping 1.50 percent.

One could replicate the bond exposures by using Vanguard's investment-grade bond fund and its high-yield fund at a small fraction of that expense ratio. For example, the Vanguard Intermediate-Term Investment-Grade Fund (VFIDX) has an expense ratio of 0.10 percent, and the Vanguard High-Yield Corporate Fund (VWEAX) has an expense ratio of 0.13 percent.

The research on the active management of fixed income portfolios demonstrates that the burden of an extra 1.4 percent in expenses makes it extremely unlikely that alpha could be generated. And since one could obtain the 10 percent equity holding at about the same (or even lower) expense ratio using Vanguard's equity funds, the same statement would hold true for that portion of the portfolio.

When we give presentations, we often mention a Futuremetrics study of U.S. pension plans, which found that 71 percent of pension plans failed to outperform a passive benchmark. What's more, the study didn't risk-adjust the returns. The passive benchmark consisted of 60 percent S&P 500 Index/40 percent Barclays Capital Govt/Credit Intermediate Bond Index. The pension plans likely invested in riskier stocks (for example, small-cap or value stocks), riskier bonds (some high-yield debt) and risky alternatives such as private equity or hedge funds. On a risk-adjusted basis, the passive benchmark looks even better.

Let's see if PKCBX has been able to outperform a simple passive benchmark or a portfolio of Vanguard funds. (Note that the fund was launched in late 2008, so there isn't much history.) We'll look at the annualized returns and returns adjusted for risk (as measured by the Sharpe Ratio). Here are the compositions, which are designed to match the equity/fixed income allocation of the fund:

Simple Benchmark -- 10 percent S&P 500 and 90 percent Barclays Capital Govt/Credit Intermediate Bond Index
Vanguard Portfolio -- 10 percent Vanguard 500 Fund Admiral Shares (VFIAX), 35 percent VWEAX and 55 percent VFIDX

It turns out the Payden fund has underperformed the passive benchmark on an absolute basis by much more than its expense ratio. And it also underperformed on a risk-adjusted basis. The main way for a mostly fixed income fund that charges 1.50 percent in expenses to outperform a passive benchmark is to take higher risk than the benchmark. This risk could take the form of:

Concentrating on a few securities
Taking more credit risk than the benchmark (which the fund does)
Taking additional term risk than the benchmark

When compared to the Vanguard portfolio, the Payden fund had much lower returns but had a higher Sharpe ratio. There are a number of possible explanations for this result, but there are two that seem the most likely. First, the Payden fund could be taking less risk with the investment grade portion of the fixed income allocation. Indeed, 33 percent of the bonds are invested in Aaa securities. Second, the fund could have made some changes to the allocation over time. For example, it could've had less in equities or less in high-yield bonds at different points in its history. Also, holding cash will lower the volatility of the portfolio while likely reducing returns.

As we have seen, despite the additional risk of the Payden fund, it hasn't been able to overcome its high expenses. The bottom line is that this looks like just another fund that was designed to be sold, but never bought.

More on MoneyWatch:
Legg Mason: Does It Add Value? Fidelity: Does It Add Value? How Are 2011's Sure Things Faring at Mid-Year? Meredith Whitney: Could She Have Been More Wrong? TIPS Update for July 2011
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Larry Swedroe

Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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