US defined benefit and defined contribution pension plans had assets of circa $16trn in 2018, according to the OECD. They invest across the full spectrum of commingled investment vehicles, and some have their own separately managed accounts. “There is nothing they cannot choose from, subject to ERISA rules,” says David Cohen, Schulte Roth & Zabel LLP (SRZ) partner in the Employment & Employee Benefits Group. Hedge fund managers could research a wider variety of investment vehicles as a way of diversifying their investor bases and catering for the diverse preferences of tens of thousands of US pension funds.
For instance, collective investment trusts (CITs) date back to 1927, clearly predating ERISA in 1974, 1940 Act funds, and other structures created by legislation in the 1930s. Total CIT assets were circa $3trn at year end 2018, and around 25% of 401(k) assets of circa $5.5trn are in CITs as of end 2017, up from 20% the prior year, according to Cerulli Associates reports.
Hedge funds have usually been wrapped in a Delaware fund, which may run parallel to an offshore fund in, say, the Cayman Islands, which will often be chosen by tax exempt investors as it is tax neutral. These “pure play” hedge funds are widely invested in by US pension funds with in-house teams that can carry out manager selection and pick individual funds. But some US pension funds, including smaller ones, are more likely to choose a “one-stop shop” solution which may be operated in-house or could be externally managed, sometimes as a multi-manager product. This might be a ’40 Act multi-manager fund, or it could be housed in fund structures, including CITs, which can also accommodate dozens of underlying asset managers.
Around 25% of 401(k) assets of circa $5.5trn are in CITs as of end 2017.
“The default option for many defined contribution pension plans is target date or glide path funds,” says Cohen. These are dominated by conventional asset classes of bonds and equities, and they adjust asset allocation with the age of the contributor. Yet there is still some room for a sleeve of alternative investment strategies, including liquid alternatives, commodities, real estate, private equity and hedge funds, if the sponsor of the target date fund so chooses. Some target date funds also have a tactical allocation overlay, which can be run along similar lines to a global macro fund. The target date market is dominated by a handful of huge US asset managers, which mainly run strategies internally, but multi-manager offerings may sometimes offer an opening for new entrants to run some assets.
Of circa $1.7trn in target date funds, circa $1.1trn is in mutual funds and circa $660 billion in CITs, as of 2018, according to Morningstar’s Target Date Fund Landscape: Simplifying the Complex. The mutual fund assets have dropped and the CIT assets have grown; some providers who offer the same investment strategies in both mutual funds and CIT wrappers are seeing assets switch from the mutual fund to the CIT.
CITs differ from some ’40 Act funds in that they are only sold to qualifying retirement plans and tax-exempt funds, including some 401(k) plans; they do not deal directly with retail investors. CITs do not have a board of directors, are not registered with the SEC and need not issue a prospectus, though their declaration of trust is similar. “CITs are run by either nationally chartered banks (suffixed NA) or state-chartered banks and are regulated by either the US Office of the Comptroller of the Currency (OCC) or state banking regulators, respectively. The bank handles regulatory oversight, and external asset managers may act as sub-advisors to the CIT,” says Cohen.
The institutional focus combined with lighter regulation can contribute to lower regulatory, administrative, marketing and distribution costs, according to most purveyors of CITs. Average expense ratios on institutional share classes of mutual funds are 0.75%, compared with 0.60% on CITs, according to Morningstar.
“As far as management fees are concerned, there are no caps per se under ERISA, but fees need to meet the reasonableness standard of ERISA. Like beauty, this is in the eye of the beholder,” says Cohen. Litigation has been brought against pension funds alleging excessive fees, and has sometimes succeeded, including in cases arguing that fiduciary duty was breached by not being invested in the lowest cost share class. The ability of aggregators to negotiate lower fees on CITs catering for multiple pension fund clients can let smaller pension funds access cheaper share classes with higher minimum investment levels. CITs could also be cheaper than separately managed accounts for the same reason.
ERISA CITs may also be more tax efficient than ’40 Act funds for some investment strategies. ERISA CITs pay zero withholding taxes on dividends in Japan, Australia, Canada, Germany, Switzerland, Sweden, the Netherlands, Finland and Belgium, whereas mutual funds — as registered investment companies — would pay a 10% withholding tax on dividend income from these countries, according to State Street. (This benefit is negated where CITs invest in mutual funds, however). Tax neutral offshore domiciles seldom have double tax treaties to reduce withholding taxes on dividends. The potential dividend benefit of a CIT is of most interest to those fund managers that run long-biased or long-only strategies that have long enough holding periods to be collecting significant amounts of dividend income.
CITs have more investment freedom than some ’40 Act structures as they do not have to be valued daily. They tend to be valued monthly or quarterly. As well as housing multi-strategy and multi-manager investment approaches, CITs can be used for single manager and single strategy approaches. “CITs have traditionally been used mainly for conventional asset classes, such as stocks and bonds,” says Cohen.
Perceived opacity had been an obstacle to wider adoption of CITs, according to a Cerulli Associates report in 2018. Pension funds members want to be able to check prices easily. Transparency and reporting can vary by state law, but the minimum levels of reporting are much less extensive than on a ’40 Act fund.
But information is available on many CITs. Morningstar’s CIT database contains circa 6,000 CITs managing circa $2.4trn who choose to submit data to Morningstar.
Wilmington Trust has partnered with Nasdaq to list tickers for some 200 CITs on Nasdaq Fund Network to provide price and performance information, which is free to view online across mutual funds, CITs, money market funds, UITs, SMAs, etc. (In March 2018, the Nasdaq Fund Network relaunched the Mutual Fund Quotation Service (MFQS), which began in 1984). The CITs will have six-letter tickers, whereas mutual funds have five-letter tickers.
Longer term, the information provided may be expanded. “The capability exists for those registering the trusts to include more granular information such as asset allocation,” says Nasdaq. Pension plan sponsors can request customised disclosures from CIT managers, and some CITs produce fact sheets that provide the same information as mutual fund factsheets.
Nasdaq’s long-term goal is comprehensive coverage. “We anticipate having near 100% coverage for CITs on Nasdaq Fund Network in the future. Our goal for the CIT market is to replicate what we did for mutual funds, where we assign tickers to all CITs in an effort to provide transparency and consistency around these products across platforms,” says Nasdaq.