Collective Investment Trusts: The Invisible Giant
Almost as large as ETFs--but far less known.
The Name Game
Collective investment trusts are big. The financial-technology firm ALPS judges that CIT assets hit $2 trillion in early 2016 and will reach $3 trillion by the end of this year. (For comparison’s sake, U.S. exchange-traded funds are at $3.5 trillion.) Morningstar shows CITs to have $2.4 trillion. Either way, there’s no doubt that CITs command substantial assets and are growing rapidly.
What is less certain is what to call CITs. Cristiano Ronaldo dos Santos Aveiro and Lionel Andrés Messi Cuccittini, the world’s best soccer players, possess fewer names than do CITs, which are variously billed as collective funds, collective trust funds, commingled funds, common funds, and common trust funds. Broadly speaking, they are also a form of separate account. But a consensus appears to be coalescing for the term CIT, which is what Morningstar (and this column) uses.
Fortunately, the tin’s contents are less complicated than the label. This article outlines how CITs operate; why they have poached customers from their more-famous competitors, mutual funds; and what concerns, if any, their shareholders should have.
Like mutual funds, closed-end funds, and ETFs, CITs are professionally managed, pooled investments. Unlike those more-familiar offerings, however, CITs are not registered under the Investment Company Act of 1940. In the nomenclature, they are private funds, not public funds. Other types of private funds include hedge funds, private-equity funds, leveraged-buyout funds, and venture-capital funds.
However, CITs are a different breed of private fund. Whereas hedge funds and their brethren use exotic investment strategies (typically, by employing leverage and owning infrequently priced securities), CITs behave like public funds. They hold mainstream stocks and bonds, while rarely leveraging. (And even then, only in moderation.) They walk and talk like mutual funds, only they are not.
CITs are created for retirement plans. Once again, this is a matter of nomenclature--conceivably, one could call a trust account that commingles the assets of a bank’s private clients a CIT. But Morningstar, along with other sources, reserves the term CIT to refer to investments that are used in tax-deferred, corporate (or government) retirement plans. These could either be defined-benefit plans or defined-contribution plans. Usually, they are the latter.
The Price Is Right
Why, you may ask, does the world need investments that are very much like mutual funds, only not quite mutual funds? There are $16 trillion in stock, bond, and balanced mutual funds. Why not instead something approaching $19 trillion, with nothing in this offshoot called CIT?
The initial reason was cost.
Funds save by being unregistered. A CIT’s initial legal expenses are lower than a mutual fund’s, as are the outlays for its ongoing reporting. However, as evidenced by the many mutual funds that carry minuscule expense ratios, once pooled funds accumulate enough assets to enjoy some scale, their operational expenditures are modest. In most cases, what drives their expense ratios are their management fees and whatever marketing/distribution expenses that they carry.
So, the real answer for CIT’s existence lies elsewhere. It is instead their ability to customize their expenses. By law, mutual funds cannot reduce their management fees to meet the request of large clients. True, the mutual fund can register a new, cheaper share class. But so far, perhaps due to the desire to avoid customer confusion, such efforts have generally stopped at two: institutional and retail classes. Not so for CITs. BlackRock, for example, has 10 versions of its Russell 2000 Index CIT, with annual expenses ranging from 0.03% to 1%. The larger the account, the lower the price.
Dodging the Law(suit)
In addition to cost, there are now legal considerations. Since the financial crisis, Jerome Schlichter of Schlichter Bogard & Denton has created a cottage industry by extracting class-action settlement payments from 401(k) plan sponsors. First, Schlichter targeted sponsors who had failed to monitor their plans. Then he went after sponsors who owned retail mutual fund share classes when their size would have qualified them to own institutional share classes. Most recently, he has suggested that plan sponsors that settle for institutional mutual funds when they could instead demand a lower-cost CIT might also be legally liable.
It is unclear whether plan sponsors truly will be liable if they don’t switch from mutual funds to cheaper CITs if they have the opportunity. Schlichter’s cases don’t often reach juries. However, it is fair to say that where Schlichter has headed, the courts have often followed. If, in his view, large 401(k) plan sponsors should forgo the legal protections of the Investment Company Act of 1940 in exchange for the lower fees of a CIT, HR departments will certainly notice.
Thus, the trend toward CITs is likely to accelerate.
Now, CITs’ disadvantages.
The obvious catch with CITs is that they do not report as public funds do. They are not required to file their portfolio holdings, or issue shareholder reports, or send their net asset values to Nasdaq’s central database. Indeed, they are not required to appear at all. Should they wish to operate silently, providing information only to plan sponsors and their shareholders, there isn’t much that Morningstar or other databases could do about that.
However, this increasingly isn’t much of a problem. For one, it is in CITs’ interest to report. Their investors don’t wish to own secret funds; they wish to own funds that are tracked by third parties, as are public funds. For another, most assets in CITs are either in index funds or in clones of public target-date funds. It’s not hard to figure out what they are doing, simply from their names.
The other concern is as previously stated: CITs aren’t governed by the Investment Act of 1940 and thus do not receive its protections. For example, CITs need not--and generally do not--have a board of directors. Personally, I side with Schlichter in thinking that this is not a major problem. Historically, mutual fund boards have gone where their management companies wish, rather than represent the interests of fund shareholders. And the strongest lever that they possess, that of lowering costs, has already been used by CITs. Nonetheless, just because CITs have not been punished for their legal structure in the past does not mean that such a thing could not occur in the future.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.