Index-based target date funds (TDFs) are designed as fund-of-fund structures in which the exposure to individual stocks and bonds is obtained through investments in various underlying index funds. For example, a State Street Global Advisors Target Retirement Fund will invest in 11 underlying index funds, with both the target retirement funds and underlying index funds structured as CITs.
State Street’s decision to use the CIT structure is driven by the structure’s advantages over mutual funds, including a greater opportunity for low-cost trading (vis-à-vis unit and security crossing), more pricing flexibility, increased portfolio diversification without additional investment management fees, and reduced tax exposure on dividends.
While most providers offer CIT structures, in some cases, mutual funds underlie the configuration, meaning TDFs aren’t able to deliver all of the benefits of a CIT structure.
The central CIT benefit is lower tax exposure, which reduces costs or increases returns, depending on one’s perspective. For example, based on 2016 tax tables, State Street’s Global Equity Beta Solutions team estimates that an ERISA-qualified CIT benchmarked to the MSCI ACWI ex US IMI Index will have a 0.16% return (or cost) advantage when compared to a mutual fund with the same investments. Given that the average TDF has a 23% allocation to international stocks,1 a 0.16% difference in return (or cost) has a material and advantageous impact on the return (or cost) of the target date fund.
The chart below shows the additional return to the State Street Target Retirement Funds based on the dividend tax benefit available in both the international stock allocation (benchmarked to MSCI ACWI ex US IMI Index) and the global REIT allocation (benchmarked to the FTSE EPRA/Nareit Developed Liquid Index):
TDFs cast a wider net of investable options to help enable greater portfolio diversification. To maximize the value of the diversification, fund managers should scrutinize the underlying indices being tracked and determine how to control for issues inherent to these investments. For example, consider the indices State Street uses for both commodities and high yield — two asset classes that are rarely found in index-based TDFs, given concerns related to the efficacy of index-based implementation.
Commodities: Importance of Roll Returns
When evaluating commodities as part of State Street’s regular asset class selection process, we were concerned that passive investors might not be able to fully reap the diversification and inflation-hedging benefits due to the roll risks. Working with members of our Global Equity Beta Solutions team (GEBS), we evaluated multiple commodity indices and selected the Bloomberg Roll Select Commodity Index. Following a rules-based approach, the Roll Select Commodity Index seeks to limit the effects of roll risk (or “contango”), which can adversely affect passive commodity investors who are neither watching nor adjusting for the rise and fall of commodity futures. Since adding this asset class to our TDFs in June 2012, the Roll Select Commodity Index has outperformed the first-generation Bloomberg Commodity Index by 1.2% on an annualized basis.2
High Yield: Managing Liquidity Risk
High yield (HY) investing offers the benefits of equities and fixed income while potentially limiting the downside risks associated with both. Used properly within a glidepath, it allows a manager to increase savers’ expected balances while also protecting against longevity risk after participants have exited the workforce.
However, HY does present the challenge of lower liquidity in the face of defined contribution (DC) cash flow requirements. That is, an HY indexer that uses a non-filtered index would be forced to hold illiquid HY securities that may suffer significantly in a market downturn if the indexer were forced to sell.
To address the strategy’s daily cash flow needs, State Street uses the Bloomberg Barclays US High Yield Very Liquid Bond Index (HY VLI). This index stands out by following simple, objective rules to deliver a liquid index while still retaining the potential benefits of HY investing. The benefits of our index selection can be quantified by the low degree of tracking error (average monthly variance of -0.04%) and strong correlation to the broader Bloomberg US High Yield Index (0.99) since its addition to our glidepath in January 2010. Furthermore, while some index-based managers argue that it is necessary to employ active management when investing in HY, the HY VLI index has delivered above-median results when compared to the Morningstar universe of active managers.
Plan sponsors’ participation in a securities lending program should be the result of a carefully considered choice, not a default fund feature. However, some leading managers are not able to offer a non-lending option, as their TDFs invest in mutual funds that automatically participate in securities lending. In such scenarios, the limit of the offering translates into limits on sponsors’ decision-making autonomy.
Within State Street’s CITs, we offer both lending and non-lending options and counsel clients to approach the decision thoughtfully by outlining risk/return objectives. For some sponsors, this assessment could reveal that the trade-offs are not aligned with organizational attitudes or DC plan values, causing them to elect for a non-lending solution. Often in these cases, sponsors are stymied by the prospect of communicating a securities lending program — and the associated risks and returns — to their participants.
For those organizations that choose lending, decision makers should become familiar with the differences between programs. For a complete picture, sponsors should look beyond lending returns to understand how revenues and expenses are allocated amongst the parties (including collateral reinvestment and manager fees), how risk management is approached, and how the risk outlook impacts returns.
Structure, index selection and securities lending dimensions may be nuanced elements of a TDF strategy, but we believe that participant and plan value is delivered in the details. It’s this point of view that pushes us toward precision and drives us to deliver better-built index-based target date funds.
1 Based on the Morningstar Industry Average Sub-Asset Class Glide Path.
2 Sources: Bloomberg, SSGA.
Collective Investment Trusts (CITs): These commingled investment vehicles, or pooled resources managed collectively in accordance with a common investment strategy, are typically maintained by a bank or trust company and are only offered to certain qualified retirement plans. CITs are not registered under the Investment Company Act of 1940 and are therefore not subject to the rules and regulations promulgated thereunder, including oversight by an independent board.
Mutual Funds: These commingled investment vehicles are typically maintained by an asset management company and are available to most retirement plans, as well as to the general public. Mutual funds are typically registered under the Investment Company Act of 1940 and are subject to the regulations promulgated thereunder.
Securities Lending: In a securities lending transaction, securities are temporarily transferred by one party (the lender) to another (the borrower). The borrowers are brokers, dealers and other financial institutions, which provide collateral in return for the loan. The lender retains the economic benefits associated with ownership of the loaned securities, such as the dividends and corporate action entitlements. The borrower is contractually obligated to return the securities upon recall by the lender. The borrower pays a fee to the lender for the use of the borrowed securities.
The views expressed in this material are the views of SSGA Defined Contribution as at 11 December 2018, and are subject to change based on market and other conditions.
This document contains certain statements that may be deemed forward looking statements. Please note that any such statements are not guarantees of any future performance, and actual results or developments may differ materially from those projected.
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. Investing involves risk, including the risk of loss of principal. The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.
SSGA Target Date Fund are designed for investors expecting to retire around the year indicated in each fund’s name. When choosing a Fund, investors should consider whether they anticipate retiring significantly earlier or later than age 65 even if such investors retire on or near a fund’s approximate target date. There may be other considerations relevant to fund selection and investors should select the fund that best meets their individual circumstances and investment goals. The funds' asset allocation strategy becomes increasingly conservative as it approaches the target date and beyond. The investment risks of each Fund change over time as its asset allocation changes.
Diversification does not ensure a profit or guarantee against loss.
The information contained in this communication is not a research recommendation or ‘investment research’ and is classified as a ‘Marketing Communication’ in accordance with the Markets in Financial Instruments Directive (2014/65/EU) or applicable Swiss regulation. This means that this marketing communication (a) has not been prepared in accordance with legal requirements designed to promote the independence of investment research (b) is not subject to any prohibition on dealing ahead of the dissemination of investment research.
© 2019 State Street Corporation. All Rights Reserved.
Exp: July 31, 2020