Mar 20, 2017
Index funds are a prominent and growing part of retirement plan design, for good reasons. The category has grown remarkably from $327 billion in 2002 to $2.2 trillion in 2015.1
In addition to low expenses, index funds offer simplicity and relative predictability in comparison to actively managed strategies. However, while index funds are commonly referred to as “passively managed” investments, they are not as simple or homogenous as many investors perceive them to be. In this paper, we provide a framework that Newport Group considers best practices in index fund selection. We recommend that investors think carefully about index selection, vehicle selection, whether to incorporate securities lending and the implementation skills of the asset manager.
The first consideration in selecting an index fund is identifying a target benchmark that is representative of the desired asset class. Newport Group generally recommends emphasizing broader indexes, which increase diversification benefits and provide a smoother ride for plan participants. Offering narrow index funds that provide targeted exposure to a specific region, country or sector is likely to confuse most participants and may lead to adverse behavior such as performance-chasing. However, the tradeoff among incremental fees, tracking error and implementation hurdles that can be associated with broader indexes should be taken into account.
We consider the index provider to be a secondary consideration relative to the addressed market. Most providers follow similar methodologies and are highly correlated within a category (99% or greater). However, all else being equal, more established index providers are preferred. We also recommend using the same index provider within broad asset classes in order to avoid overlaps or gaps that may result from differences in providers’classification methodologies. Newport Group recommends that index funds be offered in each of the major liquid asset classes: U.S. fixed income, U.S. large cap equities, U.S. small/ mid cap equities and non-U.S. equities. Our preferred benchmarks for each category are reviewed in Appendix 1.
U.S. retirement plans most often invest in pooled investment vehicles organized as collective investment trusts (CITs) or mutual funds. CITs are an increasingly popular vehicle for ERISA-qualified plans due to the potential for lower costs and pricing flexibility. CITs are tax-exempt, pooled investment vehicles maintained by a bank or trust company exclusively for the benefit of qualified retirement plans. Unlike mutual funds, which are regulated by the Securities and Exchange Commission (SEC) under the Investment Company Act of 1940, collective funds are regulated by the Office of the Comptroller of Currency (OCC) and state banking regulators. The trustees of a CIT are held to the highest standard as 3(38) ERISA fiduciaries.
CITs have traditionally been an institutional product offered by mega and large plan sponsors but have been incrementally moving down market. According to Cerulli Associates, asset managers view CITs as an optimal investment vehicle for plans with $250 million or more in assets and a viable option for plans with assets as low as $25 million.2 CITs often have a cost advantage over mutual funds due to their lower compliance, marketing and administrative costs. While mutual fund expense ratios are predetermined by the fund’s board of directors, CITs offer plan sponsors the ability to negotiate pricing arrangements based on overall plan assets. CITs are often able to maintain lower cash balances than mutual funds because participants in defined contribution plans tend to invest with longer investment horizons and inflows are typically more predictable due to periodic contributions.
Other structural advantages to CITs that can help lower costs include their ability to take advantage of internal cross-trading opportunities that lower the trading costs incurred by the fund. A cross trade is a transaction involving the internal transfer of assets between two different funds or accounts managed by the same investment fiduciary. While cross trading can benefit participants by avoiding open-market trading friction, the overall size, diversity and natural liquidity of the investment manager’s index platform often results in low-cost trades in other ways. For example, an MSCI ACWI ex-U.S. Index strategy may be modularly constructed from sizeable and seasoned commingled subcomponent trusts. The management team that oversees these country/regional funds that make up the broader strategy may allocate flows to modules that are cheaper to trade. There is also the potential for partial unit level crossing as cash flows affecting the MSCI ACWI ex-U.S. Index fund are partially offset with flows into or out of the various regional or country fund building blocks. Trading expenses are not included in fund or trust expense ratios, so this benefit is easy to overlook.
International Tax Withholding
CITs also benefit from certain tax advantages, especially with international investments, given their institutional investor bases.3 Many indexes assume maximum foreign tax withholding, but withholding rates are sometimes lower for actual mutual funds investing in those markets. However, many international developed markets provide still more favorable treatment to CITs than mutual funds. For example, Japan’s tax rate on mutual fund investors is 7% whereas CIT investors who use trusts dedicated to retirement plans pay a tax rate of 0%.4 As a result, a representative MSCI ACWI ex-U.S. Index CIT has generated about 18 basis points in excess return over a comparable mutual fund due to the tax withholding impact. Almost all sovereign debt/interest is exempt from withholding tax, so there are not similar tax benefits for international fixed income.4 Foreign tax withholding is also not included in expense ratios.
While CITs may offer advantages over mutual funds in some circumstances, they also pose unique challenges in others. CITs lack the transparency and ease of use of mutual funds for both plan participants and the plan sponsor. Daily prices are not publicly available and investment information may be limited. The compliance requirements for CITs are also generally less restrictive than those of SEC-registeredmutual funds. Finally, since CIT providers do not universally charge lower fees than index mutualfunds, plan sponsors can sometimes save by electing an institutionally priced mutual fund.
Securities lending refers to the temporary transfer of a security by one party to another in exchange for collateral that can in turn be reinvested to generate income for the lender. This practice plays an important role in providing liquidity for the global capital markets and may also generate incremental returns for investors. The primary risks of securities lending are counterparty risk (the risk the borrower will fail to return the loaned securities) and collateral reinvestment risk (interest rate, credit, duration and liquidity risk). Since the 2007-2009 credit crisis, securities lending has come under increased scrutiny by regulators due primarily to losses in the cash collateral pools.
Cash collateral pools are typically managed in accordance with SEC Rule 2a-7, which governs money market funds, or by the OCC, which regulates short-term investment funds (STIFs) offered by nationally chartered banks. The rules and investment guidelines for both have become more conservative post-crisis. The SEC implemented more conservative limits in 2010 and adopted further changes for 2a-7 money market funds in October 2016.5 In 2012, the OCC adopted new rules governing STIFs within commingled investment vehicles. The weighted average maturity (WAM) and weighted average life (WAL) were restricted to effectively mirror SEC Rule 2a-7 money market guidelines.6 The resulting cash portfolios are generally constructed of short-maturity and high credit quality securities with a high degree of liquidity. Despite these regulatory changes, it is important to review the investment guidelines to determine if securities not covered by 2a-7 are permissible.
New regulations and oversight have also reduced the risks associated with counterparty risk by requiring borrowers to hold more capital, maintain greater liquidity and reduce leverage. In addition, loans are generally collateralized at 102% of the fair value of the security being lent for U.S. securities and 105% for non-U.S. shares. The values are marked to market and posted collateral is adjusted on a daily basis.
Securities lending is a common portfolio management technique but is relatively minor strategy for most U.S. mutual funds due in part to the SEC’s strict securities lending guidelines, which impose express limits on lending, restrict the types of collateral lenders can accept from borrowers, require that the collateral be invested for maximum liquidity and address potential conflicts of interest.8 Mutual funds must limit securities on loan to no more than one-third of the fund’s total value, while commingled investment vehicles may lend up to 100% of their assets. In practice, funds and trusts both tend to lend significantly less than they are allowed.
Securities Lending Revenue
Not all securities lending revenue is received by a fund or trust’s beneficial owners. Certain managers return 100% of lending revenue, net of operating costs, to its funds and trusts, while some others retain a meaningful percentage. Managers who retain a larger portion of the revenue may have an incentive to take more risk with the collateral pool as riskier and less liquid assets typically offer higher yields.9
The scope of lending programs also vary by asset manager. Some managers only lend limited amounts of select, hard-to-borrow securities that are in high demand.10 This practice is commonly referred to as value lending. Conversely, volume or general collateral lending is the practice of lending many securities, independent of scarcity value. Managers focused exclusively on value lending generally have a lower percentage of securities on loan in its funds and lower revenue generation. Other large index providers that seek to capture and extract the maximum lending value by lending all security/loan types tend to have higher lending income.
Our Thoughts on Securities Lending
We generally do not believe that the incremental return associated with securities lending is worth the risk. For clients who are willing to incur the potential risks of sudden illiquidity in stress environments and potential losses from counterparty or collateral pool mismanagement, the decision should stipulate prudent management and risk oversight of the lending program. The expected incremental benefit is also a core component of this assessment: U.S. small cap and international funds, whose securities have higher scarcity value, generally earn larger lending premiums than U.S. large cap and fixed-income funds. Some plan sponsors may elect to lend only in those asset classes where the revenue is expected to be material.
Asset Manager Selection
Due to the perception that index funds are commoditized, the expense ratio is often emphasized as the sole criterion of the selection process. While we agree that an index fund’s expense ratio is among the most important criteria, several other qualitative attributes can allow the asset manager to add value.
- Scale – Larger index managers with significant size may have more cross-trading opportunities, which can significantly reduce transaction costs and provide higher returns.
- Significant Fund Assets – In addition to crossing opportunities, larger funds may be better able to pursue a full replication strategy in order to minimize tracking error. When fully replicating the holdings of an index is not practical, index managers often use a sampling approach, wherein the fund invests in a subset of securities that best represent the key risk characteristics of the index.
- Technology and Risk Management – Managers with sophisticated technology, systems and processes in place are able to optimize portfolio exposures and manage tracking risk more effectively, as well as systematically identify efficient trading strategies to minimize tracking error and transaction costs that are not included in expense ratios.
- Deep and Experienced Team – Deep teams with expertise in index management may be able to navigate index changes, corporate actions, cash flows and other events in a more efficient and cost-effective manner.
- Platform Breadth – Index fund companies that offer a broad and diverse range of index solutions may offer investors bundled pricing benefits. In our experience, retirement plans that can use the same manager for all of their passive investments are more likely to successfully negotiate lower fees or access lower cost share classes.
While fees are a critical consideration in the selection of indexed investment options, investors should consider additional aspects including the targeted index, investment vehicle, preferences for securities lending and other qualitative considerations. A comprehensive due-diligence process may result in improved outcomes for plan participants through superior index selection and the reduction of oftenoverlooked implementation costs.
Appendix 1: Newport Group’s Preferred Benchmarks
U.S. Fixed Income: Bloomberg Barclays U.S. Aggregate Bond Index
In the fixed-income asset class, we prefer index funds that track the Bloomberg Barclays U.S. Aggregate Bond Index (U.S. Aggregate), which provides broad exposure to the investment-grade U.S. bond market. Several low-cost, seasoned funds tracking the U.S. Aggregate are available in the marketplace.
Other fixed income indexes for consideration include the Bloomberg Barclays U.S. Universal Index (U.S. Universal) and the Bloomberg Barclays Global Aggregate Index (Global Aggregate). The U.S. Universal provides similar exposure as the U.S. Aggregate, but also includes U.S. high-yield, U.S. emerging markets, Eurodollar, 144A and commercial mortgage-backed securities excluded from the U.S. Aggregate. The Global Aggregate provides exposure to the investment-grade fixed-income market domiciled in U.S. and foreign markets. Less liquid parts of the fixed-income market, such as high-yield bonds that are included in the U.S. Universal, have proven difficult to effectively track. While the U.S. Universal and Global Aggregate indexes provide more diversified exposure than the U.S. Aggregate, implementation constraints resulting in limited fund availability make them impractical at this time.
U.S. Equities: S&P 500 Index and S&P Completion Index
Within the U.S. equity market, we recommend complementing an S&P 500 Index fund for exposure to large-capitalization equities with a completion index for exposure to mid- and small-capitalization equities. We also consider a total stock market index that provides exposure to the entire U.S. equity market a strong alternative. However, there tend to be fewer total stock market solutions available in the marketplace. Additionally, offering only one index option in the domestic equity segment of the menu, where many plans offer multiple actively managed options that are differentiated by market capitalization and style, may lead participants to overweight active management unintentionally.
International Equities: MSCI ACWI ex-U.S. Investable Market Index
We prefer international equity index funds that track all-capitalization, all-country benchmarks. These include the MSCI ACWI ex-U.S. Investable Market Index (IMI) and FTSE Global All Cap-U.S. Index, which cover approximately 98% of the non-U.S. equity opportunity set. Other popular indexes include the MSCI ACWI ex-U.S. Index and MSCI EAFE Index. The MSCI ACWI ex-U.S. Index provides similar geographic exposure as the IMI version, but excludes small-capitalization stocks. The MSCI EAFE Index is the least diversified of the three widely known MSCI international equity indexes as it excludes emerging markets and small-capitalization stocks.
Bloomberg Barclays Global Aggregate Bond Index
An index considered representative of the global investment-grade fixed-income market. It is composed of investment-grade fixed-income securities in both the U.S. and foreign countries, subject to size restrictions that vary by the security’s currency.
Bloomberg Barclays U.S. Aggregate Bond Index
An index considered representative of the U.S. investment-grade, fixed-income market. It is composed of all U.S. investment-grade fixed income securities with at least one year to maturity.
Bloomberg Barclays U.S. Universal Index
An index considered representative of the broad U.S. fixed-income market. It is composed of U.S. dollardenominated bonds that are rated either investment
grade or high-yield.
MSCI All Country World ex-U.S. Index (ACWI ex-U.S.)
An index considered representative of the equity market performance of developed and emerging markets, excluding the U.S., across large- and midcap
companies. It is composed of over 40 country indexes in developed and emerging markets.
MSCI All Country World ex-U.S. Investable Market
Index (ACWI ex-U.S. IMI)
An index considered representative of the equity market performance of developed and emerging markets, excluding the U.S., across large-, mid- and small-cap companies. It is composed of over 40 country indexes in developed and emerging markets.
MSCI EAFE Index
An index considered representative of the equity market performance of developed markets, excluding the U.S. and Canada, across large- and
mid-cap companies. It is composed of 22 developed market country indexes in Europe, Australasia and the Far East.
Russell 2000 Index
An index considered representative of the small cap segment of the U.S. equity market. It is composed of approximately 2,000 of the smallest securities found in the Russell 3000 Index based on a combination of their market cap and current index membership.
S&P 500 Index
An index considered representative of U.S. stock market performance. It is composed of the stocks of predominantly large cap U.S. companies in leading industries.
Chris MacLellan, CFA, Senior Investment Research Analyst
Gina Rowland, AIF®
, Senior Investment Research Analyst
1 Investment Company Institute 2016 Fact Book
2AB Global, Passive Mutual Funds Don’t Get a Free Pass in DC Fee
Debate, January 21, 2016
3State Street Global Advisors, Tax Benefits of ERISA Collective
Investment Trusts, April 27, 2016
4State Street Global Advisors
5Federal Register, Money Market Fund Reform, August 2014
6Office of the Comptroller of the Currency, Short-Term Investment
Funds, October 2012
7BlackRock, Securities Lending: The Facts, May 2015
8Investment Company Institute, Securities Lending by Mutual
Funds, ETFs and Closed-End Funds: Are the Risks Systemic?,
September 18, 2014
9Keane, Frank M., Securities Loans Collateralized by Cash:
Reinvestment Risk, Run Risk, and Incentive Issue, November 2013.
Federal Reserve Bank of New York; available at https://www.
newyorkfed.org /medialibrary/ media/research/current_issues/
10Vanguard, Impact assessment: Explaining the differences in funds’
securities lending, May 2016
11Barclays Capital U.S. Universal Index Fact Sheet
12MSCI ACWI ex USA IMI Fact Sheet, December 2016
FOR INFORMATIONAL PURPOSES ONLY.
Securities and investment advisory services offered through Newport Group Securities, Inc., (“NGS”), 300 International Parkway, Suite 270, Heathrow, Florida 32708, member FINRA (www.finra.org) NGS and Newport Group ae affiliated entities.
Any information presented in connection with this communication is general in nature and is not intended to provide personal investment advice. This material does not take into account the specific investment objectives, financial situation and particular needs of any investor. Before investing, investors should consult with their tax, legal, or financial advisor and obtain a fund prospectus. The prospectus contains investment objectives, risks, charges, expenses, and other information that you should read and consider carefully before investing. Past performance is not a guarantee of future results.
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