Collective investment trusts getting more attention from 401(k) advisers

Mutual funds hold the lion’s share of 401(k) assets, but another investment vehicle -— collective investment trusts — are quickly emerging as a contender.

Indeed, among the largest 401(k) plans, or those with more than $1 billion in assets, CITs already reign king, holding nearly 40% of the assets compared to 30% for mutual funds, according to a joint study by the Investment Company Institute and BrightScope Inc.

Among smaller plans, CITs’ share is much smaller — they hold between 3% and 7% of 401(k) assets for plans with $1 million up to $250 million.

CITs are catching on among retirement plan advisers for a variety of reasons, but especially because of lower costs.

“Particularly from a target-date-fund standpoint, especially with the flurry of lawsuits surrounding fees for plan sponsors, the eye is on lowering costs, and CITs are one option to lower costs,” said Jeff Holt, multi-asset analyst at Morningstar Inc.

Collective investment trusts, also known as collective investment funds, are similar to mutual funds in that they pool investor money, but they are only available to qualified retirement plans. They are sponsored by a bank or trust company, and are regulated by the Office of the Comptroller of the Currency rather than the Securities and Exchange Commission, which oversee mutual funds.

The cost savings from CITs is due to a few factors. For one, CITs generally have lower operational expenses than mutual funds. They’re restricted from advertising to the public and don’t have to file prospectuses, shareholder reports and proxy statements, for example.

CITs also have tiered pricing arrangements that grant lower fund fees as assets grow. That allows clients to “feel good about the fact they are leveraging their scale and getting lower costs,” Brady Dall, a retirement plan adviser at 401(k) Advisors Intermountain, said.

[More: The advantage of tiered pricing your advisory fees]

That’s not necessarily the case with mutual funds, institutional shares of which may be available at the same cost to a $5 million plan and a $100 million plan, Mr. Dall said.

Advisers and plan sponsors can also negotiate custom fee arrangements, unlike with mutual funds, the price of which is dictated by the fund prospectus. And since CITs aren’t available to retail investors, transaction costs may be lower, too, since 401(k) investors generally trade less frequently.

Managers are often able to maintain lower cash balances in CITs than mutual funds, reducing a portfolio’s cash drag, because redemption requests are more predictable.

Aside from cost, CITs have a few additional benefits, such as investment flexibility. For example, CITs are able to hold other CITs as underlying investments, whereas mutual funds cannot. That, in turn, can offer additional cost advantages.

PRODUCT DEVELOPMENT

According to the consultancy Callan Associates, nearly 66% of defined-contribution plans offered CITs in 2016, up almost 20 percentage points from 2012. Mutual funds, on the other hand, have decreased in prevalence by about 10 percentage points.

“I think the growth of CITs is directly correlated to the increase in advisers not wanting to use funds that have revenue sharing,” Aaron Pottichen, retirement services practice leader at CLS Partners, said.

Collective funds don’t have 12b-1 fees, so DC plans looking to eliminate or reduce use of revenue sharing to pay for plan services, thereby boosting pricing transparency, can use CITs, among other vehicles like R6 shares, to do so.

Further, product availability is increasing and CIT asset minimums are coming down, offering small plans more of an opportunity to take part in the trend. It’s also a way for active managers to compete with passive funds on cost, observers said.

“As the DC market grows, if there’s attention to fees and an opportunity to offer investors lower fees, asset managers will try to provide that to plans,” Mr. Holt said.

DRAWBACKS

There are, of course, a few potential downsides to using CITs in 401(k) plans.

For one, CITs generally don’t have readily available ticker symbols participants can research online, which could be annoying, observers said. Third-party providers like Morningstar, though, have been making information on specific collective funds more readily available to the public.

While mutual funds must value their holdings daily, CITs only have to value their assets quarterly (although most provide daily valuation). And not all qualified plans have access to CITs — for example, non-church 403(b) plans.

There could also be some additional operational difficulties associated with CITs, such as execution of a contract between the investment manager and plan sponsor. That, in turn, could involve more work from the adviser and plan sponsor in the case of switching to another fund, Mr. Pottichen said.

And, more due diligence may be necessary. When deciding whether to invest in a CIT or exit one, advisers will “want to do some homework to ensure there are no wait periods or notice periods” associated with the CIT, Mr. Pottichen said.