The Next Generation
Moving beyond mutual funds
Reported by Elayne Robertson Demby
One issue is lack of familiarity. ETFs and collective trusts, also known as collective investment trusts, or CITs, (see “Collective Wisdom,” PLANADVISER Buyer’s Guide 2009) are beginning to gain more traction with sponsors because of advantages over mutual funds, but need higher recognition from the plan adviser and plan sponsor perspective, says Ken Neward, Vice President of Sales for P & A Group in Buffalo, New York. However, operational issues play the biggest role for the lack of acceptance (see “Why Do Mutual Funds Continue To Dominate the Defined Contribution Plan Marketplace?”).
State Street introduced the first ETF in 1993 and, since then, the numbers have grown significantly, says Robert Huntsman, Director, Business Development Team, for FTSE in New York. In October 2009, there were approximately 793 ETFs offered in the U.S. and 1,768 worldwide, he says. Even in the last year, in a down market, he adds, ETF assets grew. Although, he notes, that popularity has not yet translated to the 401(k) market.
Collective trusts are basically an institutional product with institutional clients, says Fox. Mutual funds’ targeted clients, he explains, are the participants, but collective trusts’ targeted clients are the plans. Because CITs are an institutional product, they are not regulated by the Securities and Exchange Commission (SEC). “They are not a 1940 act product,” explains Fox, “so there are fewer requirements.”
CITs have existed for nearly 50 years but are not utilized extensively in the 401(k) market, explains Steve Deutsch, the Director of Separate Accounts/Collective Investment Trusts and Pensions, Endowments, and Foundations Database for Morningstar, Inc. Collective trusts were popular in DC plans from the 1950s through the 1970s, says Fox, but were relegated to the sidelines in the 1980s as mutual funds took over. Now, collective trusts are making somewhat of a comeback, says Fox, because sponsors and participants have become more aware of fund costs.
The primary advantage of ETFs and CITs over mutual funds, tout proponents, is lower cost. Collective trusts, because of fewer regulatory requirements, tend to be far less expensive than mutual funds, says Neward. Additionally, CITs have no soft dollars or undisclosed trading costs, as in mutual funds, notes Neward. “With collective trusts, disclosed costs are all in,” he says.ETF proponents argue lower costs relative to mutual funds as well, but some dispute that claim. Mutual funds usually have no sales charges but, on some platforms, ETFs have trading commissions that can add up, says Fox. When you take into account ETFs’ additional trading costs, the cost advantage disappears relative to similar low-cost mutual index funds, argues Neward. Furthermore, the cost advantages of ETFs over mutual funds is largely an advantage for smaller plans, says Fox, because large plans can offer institutional mutual fund shares or collective trusts.
ETFs, however, do offer other advantages over mutual funds besides cost. ETFs offer investors more liquidity flexibility, says Huntsman. ETFs can be traded throughout the day, whereas mutual funds can only be redeemed at the close of trading for the day (though not all retirement plan platforms that accommodate ETFs allow for such intraday trading). ETFs are also a more transparent vehicle than a mutual fund, asserts Darek Wojnar, Head of Product Strategy and Research at iShares, a part of Barclays Global Investors in San Francisco.
You can segment more specifically with ETFs, says Neward, getting just about any market segment or asset class, allowing advisers to construct detailed model portfolios.
ETFs also have advantages over mutual funds in market downturns, notes Darwin Abrahamson, Chief Executive Officer of Invest n Retire, LLC, in Portland, Oregon. Over the last year and a half, he says, investors have moved out of mutual funds, forcing managers to sell in a down market—further depressing returns. ETFs, on the other hand, he says, track the market no matter what investors do.
However, one advantage mutual funds have over ETFs is that they also give investors access to active management styles. ETFs have, until recently, only offered passive strategies but that is changing, says Huntsman, as actively managed ETFs have been launched in the last year.
When it comes to cost, the advantages of collective trusts over mutual funds, are clearer, say experts. Because of fewer regulatory requirements, costs can be 10 to 20 basis points lower than a similar mutual fund, says Fox.
The assets of collective trusts also can be customized easily, whereas a mutual fund cannot. For example, says Deutsch, if Time Warner wants no exposure to large corporate media companies, it can be accommodated.
Lack of regulation, however, can be a double-edged sword, making it hard to get information that can be used at the plan level. Collective trusts do not have the same reporting requirements as mutual funds, and often are not tracked by benchmarking and ratings companies, says Neward. Collective trusts also are not as widely known, not widely traded, and often run by regional money managers. Additionally, sponsors and advisers have to do more due diligence to learn about collective trusts and compare them to other investments.
With collective trusts, advisers get paid like any other 401(k) investment vehicle, says Deutsch, although advisers do not get direct compensation for recommending collective trusts. Advisers can get the same kinds of fees from collective trusts that they get from mutual funds, agrees Neward. Like mutual funds, some share classes have revenues built into them, while others are no-load and the adviser takes a fee.
ETFs, on the other hand, only provide an RIA fee, says Neward, and generally do not provide commissions. There is nothing comparable to a 12b-1 fee or revenue-sharing, agrees Wojnar. Advisers working with the Invest n Retire 401(k) platform must be RIAs to get paid, because the ETF-only platform does not support 12b-1 fees or revenue-sharing, explains Abrahamson. Fees are debited from participant accounts every quarter and the adviser is sent a check.
For clients, ETFs are fairly straightforward and easy to explain, sources say. CITs, on the other hand, are more complex. Too often, advisers position CITs as low-cost mutual funds, says Deutsch, but collective trusts are not proxies of mutual funds. Advisers should be aware, and make their clients aware, that a CIT is not a regulated investment vehicle. It is an institutional vehicle that is not as regulated as a mutual fund.
Furthermore, says Deutsch, the money managers running collective trusts are different from those running mutual funds; the assets differ and the decisionmaking processes for investments differ. The return stream, volatility, etc. are completely different in a collective trust than a mutual fund, he says. “We’re in favor of what’s the best solution for a plan, but everyone has to understand what they’re looking at,” says Deutsch.
ETFs have begun to make some headway into 401(k) programs, says Abrahamson. With the markets in a funk, sponsors have become more concerned with 401(k) fees, he says, and are looking more closely at investment options. As plan sponsors and their advisers become more concerned with mutual fund fees and transparency, the number of ETFs in 401(k) plans should grow, says Huntsman. New fee disclosure rules also will increase demand for ETFs, argues Abrahamson.
Some, like Joe Childrey, a TDA adviser on the institutional side, who is based in La Jolla, California, say ETFs should be in plans to the exclusion of mutual funds. “I see no reason to have mutual funds in 401(k) plans now that we have the technology to accommodate ETFs in 401(k) plans. However, for those advisers, or their sponsor clients, who don’t want an all-or-nothing solution, several companies in the last year or so have developed ways for ETFs to trade in fractional trades, similar to mutual funds, opening the door to ETFs in 401(k)s, says Neward.
CITs also should increase in popularity. The Pension Protection Act will help accelerate the adoption of collective trusts, says Deutsch, because it indicated to fiduciaries that collective trusts were an acceptable default option. That government recognition, says Deutsch, sent a strong signal that plan sponsors needed to consider CITs as an investment vehicle to meet their fiduciary obligation to find cost-effective options.Why Do Mutual Funds Continue To Dominate the Defined Contribution Plan Marketplace?
If ETFs and CITs are, indeed, cheaper than mutual funds, some ask why plans are not signing up more quickly to add these investment vehicles to their investment lineup. The main reason, experts explain, is operational. “With 401(k)s, there are lots of legacy issues,” says Huntsman. Historically, mutual funds dominated 401(k) plans, and the systems, software, processes, etc. were built to support mutual funds.
ETFs, in particular, have been hurt by mutual funds’ operational dominance, says Mike Vogel, the Vice President of Sungard’s Wealth Management Unit in Lombard, Illinois. Most platforms cannot accommodate ETFs in a low-cost seamless way to trade alongside mutual funds, says Neward. However, providers have been working to create or upgrade platforms to support ETFs. Sungard partnered with iShares to develop a solution to make ETF processes perform like no-load mutual funds on plan platforms, says Vogel. The solution was rolled out in September and accommodates both ETFs and mutual funds on the same platform. So far, the partnership has six recordkeeping clients with others interested in adding the solution to their platforms. Despite these developments, the perception still exists that ETFs are not available for 401(k) plans, says Vogel.
It is easier for recordkeepers and third-party administrators to accommodate collective trusts on their platforms, says Deutsch, because the support is already there, although it still is not as easy as accommodating mutual funds. CITs, even regionally managed collective trusts, can trade like mutual funds, so there is no reason not to include them on a platform, says Neward.
However, while close to 50% of collective trusts do have CUSIPS, says Deutsch, many still do not have CUSIPS, making it difficult to accommodate them on most platforms, as funds need them to trade on 401(k) platforms. Additionally, notes Neward, from a mass-market approach, CITs are not as widely understood, and difficult to communicate to participants versus mutual funds.
There are additional limitations on CIT adoption as well. Currently, the vast majority of collective trusts are in the largest defined contribution plans—those with $100 million or more in assets, says Fox. That is because you need a certain level of minimum assets for the economics of collective trusts to work.
That is changing, however. Collective trusts have moved down-market as the minimum dollar limits requirements have come down, making them more accessible for smaller plans. According to Deutsch, minimum investment amounts have dropped to $250,000 to $100,000 in a number of CITs, and a few even have investment amounts as low as $25,000.
“[M]ore advisers should be looking into collective investment trusts as part of their fiduciary duty,” says Deutsch, “As far as investment vehicle considerations, collective trusts deserve a seat at the table.”