Collective Investment Trusts (CITs): An Investment Perspective
Collective Investment Trusts (CITs) offer some potential benefits to retirement plan participants over traditional mutual funds. On the surface, mutual funds and CITs appear to be very similar in that they are both pooled buckets of investments. However, CITs can provide some cost and operational efficiencies not found in mutual funds.
From a cost perspective, mutual funds carry larger marketing expenses and fees associated with staying in compliance with regulatory bodies. While cost savings are important, as it gives CITs a head start in terms of performance, there are some additional considerations from an investment perspective that come into play when comparing CITs and mutual funds.
In the past, one drawback to CITs has been the slow reporting of performance measurement. However, thanks in large part to recordkeeper support, CITs have come a long way in the past 15 years in terms of the information readily available to investors. Increased coverage from Morningstar and other data aggregators has also made it easier to obtain information on CIT strategies.
Another key differentiation between CITs and mutual funds is the ability to customize the underlying investment strategy. Some retirement plans hire investment advisors to create “white labeled” CITs, where the advisor selects a variety of underlying fund managers (sub-advisors) to invest the money. For example, a white labeled CIT could be offered in a menu as “XYZ Equity” and the investment advisor has the discretion and flexibility to change the underlying fund managers as they see fit. CITs can also be created as asset allocation and target date strategies that utilize a glidepath. In this case, an investment advisor manages the underlying sub-advisor allocations and has the ability to replace a sub-advisor without requiring a blackout period for the plan and/or incurring costs of notifying participants. A target date CIT strategy could also be designated as a QDIA. CITs also provide the ability to rebalance more frequently and in a more customized manner, which can be an advantage over mutual funds.
Since CITs are only available to institutional clients (like defined contribution plan participants), there are additional advantages. Mutual funds that are available to the general public and also offered in retirement plans must keep more cash available to meet redemptions than their CIT counterparts. This can cause an incremental amount of cash drag in mutual funds, which can hurt performance.
Both mutual funds and CITs can engage in the practice of securities lending to enhance investment returns. Securities lending is the act of loaning a stock or bond to obtain collateral (cash, securities issued or guaranteed by the U.S. government or its agencies or instrumentalities, or a letter of credit) that can be used to enhance returns. The borrower is typically an entity looking to sell a security short. In other words, these stocks or bonds are “rented” out to short sellers. When the securities are returned to the fund, the collateral is returned to the borrower. The fund is still entitled to the dividends and interest on securities that have been lent out.
Securities lending does come with some risks. Most mutual funds and CITs utilize a securities lending agent who offers clients limited indemnification. The terms of the indemnity are decided between the fund and agent but, generally, the indemnification kicks in only if the borrower fails to return the lent securities and the value of those securities exceeds the value of the collateral. However, the potential for an indemnified loss is considered to be a minor risk, given the daily marked-to-market over-collateralization of the loan. U.S. Treasury Fund CITs generate about 10-15 bps in excess return from securities lending. CITs indexing the Russell 2000 can generate an additional 20 bps.
A key difference between mutual funds and CITs is that CITs do not have a cap on the percentage of the portfolio that can be lent out. Mutual funds typically reinvest collateral in high-quality, highly liquid investments. These are often U.S. money market funds that invest in accordance with Rule 2a-7, or other funds managed with very conservative short-term investment strategies.
While the Office of the Comptroller of the Currency, the body that regulates CITs, does not cap securities lending in CITs, there are limits on exposure to any one counter-party, and other factors including concentrations, credit exposure, and exposure to foreign securities (1). The typical S&P 500 CIT lends 2% to 8% of holdings, where Treasury CITs lend a slightly higher percentage. Active CITs will also engage in securities lending to the extent that their core competencies are not compromised. When it comes to leveraging, mutual funds can borrow funds to buy securities, whereas CITs cannot, as there are tax issues that prohibit this for CITs.
As CITs gain popularity as an investment vehicle in the defined contribution universe, plan sponsors should carefully consider pricing, investment suitability, and portfolio management quality in constructing a lineup for participants. CITs are subject to investment minimums and may not be suitable for every plan. The operational and investment efficiencies that drive cost savings associated with CITs are important to understand, as these cost savings are not simply a function of cost cutting. From an investment standpoint, the SEC does not oversee CITs, but the investment advisor is still subject to the ERISA standards and OCC oversight.
Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.
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