The Markets May 18, 2018

Opportunities Exist, But Future of CITs in 403(b) Plans Remains Murky

Higher education clients with very large 403(b) plans could theoretically benefit from new laws or regulations allowing them to invest participant assets through collective trust vehicles, but for most other non-profit clients, CITs might not make that much sense.
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With excessive fee lawsuits extending to the 403(b) space, and account assets growing larger with time, 403(b) plan sponsors are inquiring about offering collective investment trusts (CIT)s on their plan menu—which are like mutual funds, but tend to be at a lower cost.

According to Bruce Ashton, partner in the Employee Benefits and Executive Compensation Practice Group at Drinker, Biddle and Reath in Los Angeles, “A CIT is a trust maintained by a bank that holds assets of various types of retirement plans. They are tax-exempt so long as they meet a number of requirements. Because they are entities that invest assets for others, they may also be characterized as ‘investment companies’ or mutual funds. Absent an exemption, they would have to register as mutual funds with the Securities and Exchange Commission (SEC). Fortunately, there is an exemption—section 3(c)(11) of the Investment Company Act—which provides one for collective trusts that hold investments for qualified plans, governmental plans and church plans. The ‘maintained by a bank’ requirement is important in this context, because it means that the bank must actually control the decision-making authority over the investments.”

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According to the 2017 PLANSPONSOR Defined Contribution Survey, collective trusts overall are used by 16% of plan sponsors who responded to the survey (14.2% in 2016), and 57% of plan sponsors with plans over one billion dollars (56% in 2016). Why are more defined contribution (DC) plan sponsors using CIT’s? According to Ashton, “CITs are very much like mutual funds and can be traded essentially the same as mutual funds, but they tend to be lower-cost.”

403(b)(9) Church Plans

What types of 403(b) plan sponsors can use CITs? Ashton says, “The tax law permits virtually all types of 403(b)’s to participate. The problem lies in the securities laws: 3(c)(11) permits only qualified plans, government plans and church plans. Therefore, tax-exempt 403(b)’s can’t participate unless the CIT can qualify for another securities law exemption or the CIT registers as a mutual fund… which defeats the purpose.” 

Consequently, 403(b) plans are restricted to two types of investments—403(b) annuity contracts, and 403(b)(7) custodial accounts, also known as mutual funds.

The only exception is 403(b)(9) retirement income accounts offered by church plans as they are not subject to the investment restrictions of 403(b)s.

More DC plans are using CITs because plans are getting bigger, and with size comes the pricing power needed for access. And fees are a big issue for fiduciaries—finding the best share class—as is litigation.

Michael Sanders, principal, Cammack Retirement Group in New York says, “Defined contribution CIT usage has ticked up over the last few years because if you have a large pool of money in a qualified plan and you want to dial in the fees and not necessarily pay the share class, you might develop, for instance, your own large cap growth CIT that allows a plan sponsor to have a custom or white label fund in which the plan sponsor can name the investment and hire the underlying manager. On a large scale, it is cheaper than its mutual fund equivalent and it can allow for easier fiduciary due diligence.”

Two Ways to Deploy a CIT

Unlike a mutual fund which fiduciaries select according to the best fund for their plan demographics, this type of CIT has to be built. Sanders says, “A plan sponsor needs an RFP to hire an investment firm, codify the assets to create the structure and do the communications around it. Even though it’s not a mutual fund you have to communicate to your participants what you’ve done. Unless you have enough funds to build something it could end up costing a plan sponsor more money.”

Ironically, Sanders says, “Most church plans, the only type of 403(b) plan that can use CITs, do not have the scale to take advantage of these custom CITs because a plan sponsor has to have at least a billion dollars to build their own and many church plans are fragmented. Many parish plans are run individually, folding up to one board or the parishes have multiple vendors.”

But as an alternative, and perhaps further frustrating to 403(b) plan sponsors, many investment management firms are creating CIT versions of popular mutual funds to enable them to lower costs. Mutual fund companies have come out with CIT versions of their mutual funds or target-date funds allowing easier access to the advantages of CITs for plan sponsors. All qualified plans other than 403(b) plans, no matter their size, can take advantage of these vehicles, as can 403(b) church plans.

The 403(b) plan law was enacted in 1958 and at that time plans could only offer annuities. In 1974 the Employee Retirement Income Security Act contained a provision that allowed 403(b) plans to offer mutual funds, and a 2015 law allowed church plans to offer CITs.

Higher Education Missing Out

But, Sanders says, “where these CITs could work well is in higher education. These plans tend to be larger and potentially have the scale it would take to drive down fees for the participants. CITs would allow higher education plan sponsors to provide an array of investments and few communication changes. They could also clearly label each investment to allow for easier communications. Participants could have their asset allocations set up and not be deterred by a fund that isn’t doing well. That’s happening underneath the engine so they don’t get caught up in that. But, it’s not available to them.”

Administrators at the University of California (UC) clearly agree that CIT’s have an advantage in higher education retirement funds. The UC began offering collective investment trusts for its 403(b) plan in the fall of 2017, marking a rare instance of a 403(b) plan, other than a church plan, offering such an investment option.

The university benefited from a private-letter ruling from the Internal Revenue Service (IRS). Although the IRS letter provided an exemption for prohibitions​ on non-church 403(b) plans offering collective investment trusts, the university declined to provide the letter, describe a summary or say when the ruling was issued.

Ashton says that the UC private-letter ruling “appears to have been a one-off and that they were able to ascertain a no action letter from the Securities and Exchange Commission. If a sponsor is not certain if an action violates the securities law it basically goes to the Securities and Exchange Commission and asks something such as in this case: ‘If our 403(b) holds certain types of investments are we going to be required to be registered under the investment company act, and the mutual fund act?’ According to news reports, the SEC issued a no action letter but the letter could not be located.”

The Future of CITs and 403(b)s

When asked if any rule changes in the 403(b) market might allow CIT usage, Sanders said, “ultimately mutual fund fees have been coming down, and the majority of 403(b) plans are smaller—it’s a non-issue. They would not be taking advantage of CITs anyway.

“But in the larger 403(b) market, it would be very good if CITs were available. I don’t know that anything will change. I don’t know that this one piece of the code (the Internal Revenue Code) will garner the amount of attention it will need to make it happen. But if it did happen, it would be a good additional tool that large plan sponsors would have, and the UC is a great example of a large plan sponsor that can take advantage of this.”

Ashton adds, “Theoretically 403(b) plan sponsors would save money by using CITs. The value of the CIT is that since it doesn’t need to register under the federal securities laws, plan sponsors don’t have the cost of registration/prospectus preparation and keeping a prospectus current so there’s a lot of savings on the part of the CIT. It operates and trades almost like a mutual fund but doesn’t have the associated expense of being a mutual fund.”

In addition, Ashton says, employees in industries that use 403(b) plans such as health care industries, schools, and other non-profits are paid lower than many industries that use 401(k) plans and they could gain more from the use of CITs. “Generally speaking 403(b) plan sponsors have been less involved or not involved at all with their plan and, not to disparage the insurance brokerage industry, they have seen this as an opportunity to make a nice piece of change by serving as the adviser to 403(b) participants. Brokers receive a very healthy commission on the annuity products and mutual fund shares.”

The Markets May 11, 2018

‘Dilution’ Can Derail Outperformance in Institutional Factor-Based Portfolios

In conversation with PLANADVISER, Northern Trust Asset Management’s head of quantitative research steps through some of the pros and cons of using factor-based portfolios and so called smart-beta strategies; he sees big opportunities, but also warns about the “dilution” phenomenon.
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Continuing a string of exclusive question-and-answer sessions with PLANADVISER editors, Mike Hunstad, head of quantitative strategies for Northern Trust Asset Management, took a deep dive into the complicated subject of factor-based investing within institutional portfolios.

According to Hunstad, many types of institutional investors, including defined contribution (DC) and defined benefit (DB) retirement plans, have started to embrace factor-focused portfolios and smart-beta strategies as a means of achieving excess returns. With the latest bouts of market volatility there has been something of a rush into the low-volatility factor, he notes, but other factors are also receiving increased client attention.

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Many institutions have found real success with factor investing and smart-beta, Hunstad suggested, but there are some emerging challenges that investors must be made aware of. In particular, he warns that institutions may be trying to implement too many factors at the same time without considering the complex interplay between sources of portfolio risk and returns.

PLANADVISER: I understand you are the head of quantitative strategies for Northern Trust Asset Management. Can you define that role for us and tell us about what your daily work entails? How much are you focused on the subject of factor investing among institutional investors?

Mike Hunstad:  I’m glad you asked that, because the bulk of our mandate for quantitative analysis today is centered on factor research. My team is responsible for factor-based research and product development for equities and, increasingly, within fixed income. We have grown tremendously in the space in the last several years in terms of assets, and so the conversations we have on a daily basis really have changed as well.

When I started on this work six years ago, we were still focused on basic education around this topic—what is a factor? Why does it exist and why does it offer an opportunity for pursing outperformance? That sort of thing was our bread and butter. Years later the conversation is much more sophisticated and we are focused on some of the more complicated and challenging institutional implementation issues.

We have started to see the trend of virtually all of our clients, and all the conversations we are having with prospects, moving away from single factor implementation into a multi-factor context. This has brought really a whole new level of required sophistication and new considerations about what the potential benefits and pitfalls of factor investing are for institutional clients.

PA: I understand that in a recent review of more than 300 institutional portfolios, Northern Trust Asset Management has found a very common problem leading to underperformance. You refer to it as ‘dilution,’ and warn that a lack of sophistication around factor-based portfolio design can cause the benefits of individual factors to cancel each other out, especially in this context of institutions trying to take advantage of multiple factors at the same time. Can you give us an overview of this issue?

MH: The motivation behind this research was addressing what to some investors appears to be a contradiction. On the one hand we have spoken at length in the past about the efficiency and excess returns that can be found in factor implementation, but this efficiency has proven to be difficult for some investors to achieve in practice. The main challenge they face is that any time you tilt with real conviction towards a given factor, it doesn’t matter which, if you are not careful there is going to be a strong tendency to take unintended bets and thus to carry unintended risks. This can potentially cancel out any excess return you are going to earn from managing towards that factor.  

Consider an example. Let’s say that you have tilted towards the low-volatility factor in the last couple of months, which would make sense for many institutions in this uncertain environment. If you were not careful and thoughtful, this would have brought you towards a strong exposure to utilities and consumer staples and would probably have resulted in a large-cap equity bias, and you may even have moved towards a negative value-factor bias, meaning your stocks are more expensive on average. Overall this portfolio may serve some of your needs, but you can also very quickly start to develop a lot of unexpected, idiosyncratic risk that sneaks in, such that you think you have low volatility but in fact you have added other unanticipated risks and canceled this out. We call this ‘dilution’ of risk-adjusted returns one of the main enemies of achieving the factor performance you expect.

You can see just by looking back at the market performance how these unanticipated risks could damage portfolio performance. Anyone who took on a great deal of exposure to public utilities and real estate—which are bond proxies—in the first part of this year has not had a great time. So we see a lot of very unhappy low volatility investors sitting out there right now who found themselves being surprised by unintended risk factors they took on while attempting to craft a low-volatility strategy. The important takeaway here is that factor-based portfolios must be reviewed to ensure they are not taking unintended bets and risks. You want as pure implementation of that factor as you can get. In our low-volatility strategy, for example, we work to make sure there is not an unexpected over-concentration to utilities or indeed to any one sector. This has paid off year-to-date, because we are sector neutral, region neutral, and style-factor neutral.

PA: You also have framed the ‘dilution’ challenge in terms of ‘over-diversification.’ Can you explain what you mean by this?

MH: This challenge of getting the most out-of-factor-based portfolios, of course, also ties into the idea of diversification, and now we are increasingly talking about the concept of over-diversification at a portfolio and strategy level. If you become aware of the unintended risks in your factor portfolio but are not very careful about how you diversify away from those risks, you can also run into problems. So in the current example of moving towards the low-volatility factor, you will have to ask, how am I going to diversify away from the utilities risk, the consumer staples risk, and the other idiosyncratic risks? In answering this question, it is actually quite easy to jeopardize your factor convictions and throw the baby out with the bath water, so to speak. This is the concern we are talking about when we mention over-diversification and ‘dilution.’

Remember, the reason why we invest in factor portfolios in the first place is that we are looking to improve risk-adjusted returns. Factors have been demonstrated to both improve risk-adjusted returns against the market and also offer lower correlations. But a lot can happen between acknowledging a potential factor advantage and then putting it into practice. Whether targeting one factor, two factors or three factors, the more complicated our thesis might be, the more likely it can become that we are introducing dilution into the portfolio—especially the aggregate portfolio of a large institutional investor. In short, dilution can undue both our performance convictions and the diversification effort as we are trying to push our portfolio out onto the cusp of the efficient frontier.

The topic of dilution, viewed from both of these perspectives, is increasingly important right now, because more and more investors are seeking ways to use more than one of these factors at the same time to pursue excess returns.

PA: I have heard you use the phrase, ‘get paid for the risk you take.’ Can you talk us through in more detail what you mean by getting paid for taking risk? That’s the ultimate source of market returns, after all, so perhaps that is a good framework for understanding this whole conversation?

The number of factor-based strategies has significantly expanded in recent years as investors seek to capture excess returns from well-defined compensated risk factors such as size, value and low-volatility. Despite targeting the same factors, however, these strategies can produce very different returns. Our research has shown that this is the result of unintended exposures to uncompensated risk factors, which can range from sector concentration, unanticipated leverage, etc., that contribute to risk but not to returns.

To measure the overall appropriateness of a factor strategy—to make sure you get paid for the risk you take—we have created a new metric called the factor efficiency ratio (FER). For a strategy to have a high factor efficiency ratio, it must have a combination of high intended factor exposure and low unintended risk exposure. We confirmed this concept by analyzing the FER, to determine factor purity, and Sharpe ratios, to calculate risk-adjusted returns, of a number of popular smart beta strategies. We saw that a higher FER did in fact produce higher risk-adjusted returns.

PA: Can we take a step back and discuss the widely held belief that the ‘value factor’ has underperformed over the last decade? As a result, we hear about plan sponsors and advisers shying away from using value as an investing theme. You have suggested this is a ‘complete misperception’ and that, in reality, value has outperformed and has been the second best factor performer behind momentum.

MH: Yes, this is an important and related point to what we have covered so far. Whenever we look at factor returns, we have to be very careful about defining the return of the factor itself versus defining the return of the particular implementation of the factor.

Let’s say you have a value indexed investment right now, and you look at this index and it shows you have underperformed the broader market, do you jump to the conclusion that the value factor is to blame? Using the same logic we have been discussing, you can’t really do that. When you look at the value index, it may actually be that your particular implementation of value involved some sector-concentration bets that did not end up paying off—or you might have had other idiosyncratic risks or style factor exposures that did not pay off.

The lesson is that, we cannot be so quick to say that ‘value has underperformed’ or ‘low-volatility has underperformed,’ without first going in and doing the quantitative work of disaggregating the returns in terms of the influence of the factor or factors, versus the influence of those unintended bets and exposures that have crept in along with your factor exposure.

So, sticking with value, we have seen clear evidence that you have to be really careful about making a claim about the performance of any given factor without taking into account all the other elements of risk and return. When you do this and back out some of the sector bets inherent in value indexes, the picture changes dramatically. We see that the influence of these unintended bets can be really dramatic and totally outshine the influence of the factor in question.

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