What determines an individual’s universe of investments?
Imagine you have spare cash you’d like to invest. You don’t have the time or expertise to individually purchase stocks and bonds, so you use professional managed investments. If you are a typical investor, doing your own research or talking to a financial advisor, you’ll probably end up with a combination of traditional investments like mutual funds, exchange traded funds (ETFs), or maybe even an annuity.
Consider the mutual fund: you are buying shares of a collective pool of stocks and bonds with many different owners. Maybe you like a particular mutual fund strategy, but there are one or two stocks in the pool you don’t want. Is it possible to customize the mutual fund by omitting certain stocks? Better still, could the portfolio manager buy individual stocks on your behalf, but let you slightly adjust those holdings for tax reasons or personal preferences? Could you have the same portfolio manager making decisions, but avoid the collective pool? Sure you can: that investment structure is called a separately managed account (SMA). A portfolio manager will require more dollars to be able to buy individual stocks in your name and adhere to the same investment strategy as the much larger mutual fund, but modestly wealthier clients can carve out enough assets (usually a few hundred thousand dollars) for a separately managed account instead of buying shares of a mutual fund. Thus, the investment strategy between mutual fund and the SMA may be identical, but the investment structure or vehicle can differ. Moreover, when considering the totality of CITs and SMAs (without regard to whether they have a corresponding mutual fund) vs. mutual funds, “The Performance of Separate Accounts and Collective Investment Trusts” by Elton, Gruber, and Blake suggests separate accounts have a slight performance advantage over mutual funds
Truly wealthy clients – with millions of dollars in investible assets - might qualify as an accredited investor or qualified purchaser. Qualified purchasers get access to more exotic options, with hedge funds, membership with IPO syndicates, private placements, private equity, and other potential investments.
In short, an individual’s universe of investment options expands as wealth increases. Wealth increases the types of investment strategies and it allows investors to select customizable investment structures. There are a few investment strategies, typically illiquid investments such as private equity, which are only available to the wealthy. However, the options available for wealthier individuals are not necessarily superior. However, individual investment goals can be achieved with traditional investment structures like mutual funds and ETFs, if you are sure to apply fiduciary standards to your investment selection process. Even previously inaccessible alternative investment strategies (e.g. a merger arbitrage hedge fund) are now available in a traditional mutual fund structure.
What determines an institution’s universe of investments?
For foundations, endowments, and other charitable organizations, the original rule applies: investment access improves with greater wealth. In this case, however, the additional access to risky, unregulated alternative investments may serve greater purpose. Charitable organizations often exist to promote their mission in perpetuity. With a potentially infinite time horizon, charities can take greater advantage of exotic investment options which may only pay off over decades – a luxury of time individual investors cannot generally afford.
For sanctioned retirement plans, like a 401(k), we can add another element. US retirement plans can invest into specially created structures – like stable value funds or collective investment trusts (CITs) - which exist specifically for these clients, regardless of the size of the plan. Collective trusts are only available to tax-exempt plans, like ERISA qualified retirement plans. Individuals cannot use them in an IRA. Non-qualified deferred compensation plans can’t use them; 403(b) plans can’t either. Legal status determines which investments are permitted.
The practical upshot of this fact is an average person on the street is totally unfamiliar with collective investment trusts. However, CITs are not complicated. Collective trusts are co-mingled investment pools – just like mutual funds – but they are often specific to individual recordkeepers, banks or trust companies. For example, if you personally want to buy shares of Vanguard’s S&P 500 mutual fund, you could transfer money directly to Vanguard, or work with a wirehouse financial advisor like Merrill Lynch or Morgan Stanley, or use an online trading platform like Schwab or TD Ameritrade.
In contrast, if a retirement plan sponsor for a 401(k) plan has employee assets custodied at T. Rowe Price, the CITs they will be likely be offered are from T. Rowe Price’s own suite of products. Competing CITs from other companies tend to be historically limited or more expensive to bring onto a new platform. There is a trend for recordkeepers and custodians to offer open-architecture, and offer non-proprietary investments to retirement plan clients, but it is not universally true yet.
CITs often mirror mutual funds…
So, is a CIT just a mutual fund that’s offered to a retirement plan clients? Sometimes, that’s essentially true. Sometimes the mutual fund and CIT truly follow the same investment strategy with minimal differences to investment structure and performance. This is often called a clone fund or a mirror fund; the strategy is identical, but the structure of the investment or vehicle differs.
…but not always
Conversely, there are a number of CITs which exist on their own, without a mirrored fund. For example, some target date fund series – Callan Glidepath CITs, Principal Hybrid CIT – have no corresponding mutual fund. Thus, retirement plan clients looking for candidate investments for their lineup need to keep CITs in mind because these are investment products you might miss unless you did a specific search for CITs.
What makes matters genuinely confusing is when there are mutual funds and CITs with similar names and the same parent company, but the mutual fund and CIT follow different strategies with different portfolio managers, different underlying sub-managers, and so on. For example, Schwab’s Managed Retirement Trust Funds, their CIT series, are very different than the Schwab Target Retirement mutual fund series. The underlying managers in the mutual fund series are predominantly Schwab products and from Schwab owned subsidiaries. In contrast, their CIT series uses a much higher proportion of external money managers (Loomis Sayles, William Blair, Templeton, Dodge & Cox) in combination with proprietary Schwab investments.
The upside of CITs
Why use CITs at all? The primary advantage for a CIT is that it is often less expensive than a comparable mutual fund. Invesco reports suggest CIT fees are 25-40 basis points (0.25%-0.40%) less expensive than comparable mutual funds on average. Second, since CITs are designed for retirement plans, they can often be quite flexible in terms of the revenue sharing options which pay for administrative costs of the plan or the advisor (if he or she accepts indirect compensation). Plan sponsors can save on fees by using a collective trust than a mutual fund, whether a passive or an active strategy. Finally, there are plenty of good investment options only available as a CIT vehicle. There is no inherent reason to exclude them from consideration.
The downsides of CITs
So, what’s the downside to CITs? First, we know CITs are often cheaper than mutual funds, but why? Collective trusts are cheaper because they have fewer regulatory reporting requirements since they are excluded from definition of a registered security. They aren’t allowed to advertise using mass media. Thus, there are no 12-b1 fees, so there is less overhead for the CIT provider. CITs are still regulated through the Office of Comptroller or state banking examiners instead of the SEC, but critics argue CITs face less oversight, scrutiny, and applicable legislation than traditional investments.
Second: CITs return streams, underlying holdings data, and other operational data is often omitted from widely used databases, and as a result there is less peer comparability when compared to traditional mutual funds. Comparability is a key element to demonstrating fiduciary compliance; CITs are harder to compare against peers. Thus, CITs require more due diligence effort from the investment or plan committee which selects them.
Third: reporting is more difficult for CITs. Individual plan participants and investment committee members have come to expect daily transparency on their investments. CITs don’t have a ticker symbol, and performance reporting flows through the CIT manager. You have to trust them to report accurately and in a timely matter.
There are other concerns which committees should be mindful of. For example, CITs are often bundled into recordkeeping and custodial relationships, making them less portable for plan sponsors. ERISA required Form 5500 filings have been historically more challenging using CITs. A thinly used CIT might impose additional fees, anti-dilution expenses designed to counteract trading costs with entering or leaving the portfolio.
Finding a CIT and reporting results
Imagine your investment committee has considered the pros and cons of CITs and you’d like to learn more. Let’s conduct an investment search for CITs and compare these candidates to other mutual fund options. Already, depending on your capability (or your investment consultant’s capabilities), you may run into trouble.
When you’re selecting an investment for your retirement plan investment lineup, you follow a fiduciary process for determining which investments are considered. You don’t rely on hearsay, personal relationships, or picking the first option presented to you by a salesman. In fact, once you open up your screening process to CITs, you most definitely should be considering all CITs, at least until you screen them out with a fiduciary process. Historically, the CIT business model has run counter to the fiduciary process for selecting an investment.
How so? Investment selection screens and searches are conducted against professionally maintained databases with thousands of investment options. Common databases include Zephyr, Morningstar, Thompson Reuters Lipper, and so on. Why? CITs have historically eschewed advertisement and were not commonly available on competing platforms anyway. Thus, salesmen instead sold CITs directly to clients already on their platform.
CIT data is often not available on investment databases, and this makes the selection process difficult. Allow us to get into the details for a second:
Imagine you’re considering swapping an S&P 500 CIT for an existing S&P 500 mutual fund already being used a retirement plan lineup. The client knows what they want to do, but needs to run a search for the investment to demonstrate that the new CIT passes the same screening criteria as a comparable mutual fund. This should be straightforward, but the listing for the CIT in the investment database has sparse information. Maybe the CIT shows up as available, but presents less information as the comparable mutual fund. The CIT in the database includes information about performance history, but lacks information about the portfolio manager, his tenure, ownership level. If these criteria make up part of the existing fiduciary process for selecting mutual funds, it is difficult to omit them from the CIT search.
This is actually an optimistic scenario. We’ve seen cases where imagine the investment database acknowledges a CIT exists, it has a listing the data, but there isn’t any performance included.
Worst of all, the managers of the CIT have not bothered to get in touch with investment databases so the CIT doesn’t even show up with a listing. It doesn’t exist in the database. To conduct a screen, data has to be manually uploaded from one system to another for any semblance of a fiduciary process to continue. Whenever these transfers of information happen, there is always the potential for errors. Since the client or consultant began the request for an information transfer, the burden for double-checking the information on behalf of the analysts, consultants, investment committees is higher.
The additional attention on cost savings within the US retirement system has resulted in additional interest in CITs. With this additional interest, these issues with limited information are being addressed and CIT reporting has improved. Several tools and databases have also expanded their services to include CITs in investment searches, but data availability is still work in progress.
Levels of due diligence: operational and investment
When conducting due diligence as part of your investment selection process, there are generally two types of due diligence: investment level and operational level due diligence. We’ve discussed investment level due diligence in several articles before. As a reminder, investment due diligence focuses on the strategy itself, quantitatively and qualitatively. What quantitative metrics characterize the investment historically? Relative to peers, how are returns, risk-adjusted returns, and other numeric features. Qualitative features – the process, people, philosophy, and parent behind the investment - are equally important to investment level due diligence. Every investment – SMA, mutual fund, direct investment, and CIT – undergoes investment level due diligence.
Operational due diligence is different, and ignores the goal of the investment altogether. Rather, operational due diligence focuses on business operations. Who custodies the assets and who is auditing these assets? Who vets and confirms regulatory filings, if any. How strictly does trading behavior follow the precepts of best execution? Are there preferences for large orders for separately managed accounts? The bar for operational due diligence is lower for regulated products with daily liquidity, like a mutual fund. Truly unregulated entities, mostly alternatives like hedge funds or private equity products, require the most operational due diligence. Still investment structures with different levels of regulatory oversight, like CITs, still require modest additional operational due diligence effort.
Back to investments, how many investment committee members are comfortable conducting an additional level of due diligence? Are they equally comfortable with operational due diligence and investment due diligence?
Before this process seems too daunting for plan sponsors to undergo, consider the good news. If a plan sponsor considering adding a cloned or a mirrored CIT (a CIT with an already vetted mutual fund counterpart), the investment committee’s job is simpler: they just have to account for the differences between the products. What might account for differences in performance, holdings, and administrative features of the fund? For example, CITs can’t invest in certain underlying securities which a comparable mutual fund clone investment could. There are, for instance, securities which throw off unrelated business income tax (UBIT); these underlying securities might be in a mutual fund, but not the CIT clone fund. The omission of a few securities can create minor differences in return streams between ostensibly identical strategies, but both may be perfectly acceptable.
Industry defense of CITs
It seems like a headache for a recordkeeper or custodian to create and market these products, so you have to wonder: What is the incentive for the CIT distributor? First, attracting clients. If the primary factor that an investment manager is using to evaluate options for the retirement plan lineup is fees, than a CIT is likely to be cheaper than a mutual fund version of strategy. That small amount of edge may be just what you need to get a new client.
Next reason? Client and asset retention. CITs are only available through ERISA plans. Imagine John Doe is an employee in a plan which uses CITs. John retires. If John had mutual funds, he could transfer his existing mutual fund shares directly into a competitor’s IRA. He can’t do that with a CIT. It’s a hassle for John to sell CIT shares, rollover the cash into a separate IRA, and repurchase something comparable. So, more assets stay invested in the CIT, earning fees for the custodian and investment manager.
So, investment managers who develop and promote CITs will defend their use. Investment manager offer continuing education web seminars, and newsletters to promote the use of these strategies. They’ll highlight potential savings and customizable revenue sharing options for retirement plan sponsors, improved communication efforts, and enhanced portability options (trading via the NSCC platform) for CITs. These efforts seem to be working, with Invesco and Pensions Investments report rapid expansion of CITs in the retirement space. Aon Hewitt and Callan report that 30.6% plans use CITs in 2016, up from 13.2% in 2011.
The final word
So, how should we think about CITs vs. other investment options? It might help to consider the differences of a full service grocery chain and a discount grocery chain, like PriceRite or Save-A-Lot. Full service grocery stores will bag your groceries for you when you leave the store. Discount grocers expect you to bag your own groceries and they will charge you extra dime for plastic bags. Discount grocers have a smaller number of brands on shelves, more generic brands, and often sell lower quality produce. On the plus side, they can sell food at significant discounts compared to full service grocery stores.
First consideration: do you look at the discount grocer as passing on savings to the customer? Or do you see additional staff to bag groceries or free plastic bags as valuable services worth paying for? In other words, discount grocery shoppers are sacrificing time and perks for additional savings. Maybe we can regard CIT users similarly: they are sacrificing the time and effort to conduct the additional due diligence for lower fees.
Second consideration: most of us feel reasonably component when it comes to bagging our own groceries, so we can appreciate both sides of the trade-off at a grocery store. We aren’t forced into one choice. On the other hand, operational and investment level due diligence is more complicated than bagging groceries, so maybe investment committees, particularly those without trusted consultants to spearhead due diligence efforts, might feel constrained into the full service option.
CITs aren’t always better because they’re cheaper. CITs aren’t always worse because of the additional burden. Some retirement plans use them. Some retirement plans have considered and rejected CITs. What’s right for your plan? It depends on the willingness and ability of the investment or plan committee to absorb more responsibility in exchange for plan cost savings.