The cafeteria at my college dorm used to periodically serve up what we'd jokingly refer to as "mystery meat," an unappealing entree of indeterminate origin. When the Bolognese sauce on offer at Monday lunch looked suspiciously like Sunday night's chili, the choice was clear: a bowl of Golden Grahams. Again.
Some 401(k) participants may feel like they're navigating a version of that same cafeteria line, especially if they work for a larger employer whose 401(k) lineup features a lot of choices. As I was helping a friend allocate her 401(k), for example, I spied well-known funds like Dodge & Cox Stock (DODGX) and Fidelity Contrafund (FCNTX) alongside no-name options such as "Large Cap Growth Fund" and "Small-Cap Equity Fund."
When confronted with such a lineup, your natural response might be, "Fidelity Contrafund and Dodge & Cox Stock (or T. Rowe Equity Income (PRFDX) or Vanguard Wellington (VWELX)) all the way." After all, 401(k) participants may take great comfort in knowing their retirement assets are in the hands of one of the investment world's best-known names, and many 401(k) fixtures are there because of these funds' popularity and their solid past performance.
But that doesn't mean you should completely bypass the non-name-brand funds--usually called collective trusts--particularly if you're willing to do some homework up front. Facts about such investment options won't be as easy to dig up as with traditional mutual funds, and if your 401(k) plan won't provide you with the information you need to make informed decisions, I say skip the collective trust. But some collective trusts feature low costs and topnotch managers who don't manage mutual fund assets, and collective trusts may be your only options in a given asset class. Here are some of the key considerations to bear in mind before you invest in one of these vehicles.
Collective Trust Basics
In contrast to funds like Dodge & Cox and Fidelity Contrafund, the typical person on the street can't invest in collective investment trusts because they are not open to the public. Instead, they are run explicitly for institutional investors, such as with 401(k) plans and insurance companies. Stable-value funds, mainstays of 401(k) plans that offer stability of principal and higher yields than those of money market funds, are typically collective trusts. A high percentage of collective trusts aren't actively managed but rather track market benchmarks; while not technically mutual funds, they're a lot like index funds.
That institutional-only focus has an important side benefit: Just as individual investors can swing a better deal on investment-management fees when they pool their money together via a mutual fund, so can institutional investors obtain lower fees when they pool together the assets of other institutional investors. Collective trusts don't have to market themselves like mutual funds do, nor are they subject to the same regulatory regime or reporting requirements that mutual funds are. They're monitored by bank regulators rather than the SEC. Although this regulation framework has its drawbacks (more on those in a second), the net effect of having to file less paperwork and hire fewer lawyers is that the collective trust fees might be lower than those of mutual funds in the same category. For example, the median expense ratio for domestic-stock collective trusts is 0.69% versus 0.90% for the median institutional share-class domestic-stock mutual fund. The median expense ratios for R shares and no-load domestic-stock mutual funds--share classes that also frequently appear in 401(k) plans--are 1.20% and 1.00%, respectively.
The typical collective trust also has a cost edge versus the average mutual fund in the international stock and fixed-income classes. As noted above, the collective trust universe features a higher percentage of passively managed funds than is the case in the mutual fund world; that accentuates collective trusts' cost edge as depicted by averages.
Collective trusts may also feature fund managers who, for whatever reason, do not run mutual funds at all. That doesn't necessarily make them better than mutual fund managers, but having an institutional focus does mean that collective trust managers will tend to hew closely to very specific investment mandates. If you strongly prefer that a manager stick with a single investment style (for example, you don't want your small-cap manager to graduate into mid- or large-cap stocks), you're likely to get that style purity with a collective trust.
Finally, one other key reason not to ignore collective trusts on your 401(k) menu is that in some cases the collective trust option may be the only investment choice in a given category, and there's a general trend in the 401(k) industry to supplant mutual funds with collective trusts. Back to my friend's 401(k), for example, the no-name "Small-Cap Equity Fund" was the only small-cap offering of any kind inside her plan. So if she wants to own small caps in her retirement plan, it's the collective trust or the highway.
Beware of the Following
The key drawback for 401(k) investors eyeing collective trusts, however, goes hand in hand with the advantages. Because collective trusts are set up for institutional investors, the information they provide is generally geared toward pension or 401(k) plan providers, not the end participants.
U.S. mutual funds are required to provide a high level of disclosure--arguably the highest in the world--including daily prices and quarterly holdings, as well as clear details about who's running a fund and what it charges. In contrast, 401(k) plan participants in collective trusts may not readily be able to put their hands on the same level of information. Some employers may provide their employees with a lot of information about who's running a collective trust, what it charges, and how it is performing on a day-to-day basis; other employers might be more stingy. Although we track the data in-house, Morningstar.com doesn't include information about specific collective trusts, so you can't check up on collective trust data on the site or integrate a collective trust holding into our portfolio-monitoring tools.
The regulatory requirements for collective trusts are also less stringent than is the case for mutual funds. One key differential is that mutual funds have boards of directors that are in place to serve investors' interests. Those boards vary in their effectiveness-- Morningstar Stewardship Grades help evaluate them--but they are an additional safeguard that collective trust investors don't have. That doesn't mean that no one is watching over your 401(k) options: All investment options in 401(k) plans are governed by ERISA law. In short, that requires their overseers to act as fiduciaries and make sure that the plans are set up to serve their investors' interests.
How to Check Up
So how can you conduct due diligence on collective trust offerings in your 401(k)? Start by combing through your plan's Summary Plan Description, annual report (Form 5500), and additional materials available on the company website or in the employee handbook for details about the collective trusts' managers, fees, investment strategies, and performance track records. Don't be shy about asking your employer or plan administrator for additional details and ask your colleagues to do the same; the demand for information will drive your employer or plan administrator to make it available.
If you're lucky, you may also be able to find a mutual fund clone of the collective trust in your plan; you can then use that clone as a proxy for your actual holding to help draw conclusions about management, strategy, and performance. If you can get your hands on a manager name, that's the best way to identify mutual fund clones; you can then use Morningstar.com's Premium Fund Screener to search for mutual funds run by the same manager or team. Use any other collective trust information your plan provides--such as return histories or top 10 holdings--to corroborate that the mutual fund is a good proxy for the investments in your plan. If you determine it is, you can then use the mutual fund to stand in for your actual holding in Morningstar.com's X-Ray and Portfolio Manager tools.
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