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Fidelity Taps Alternative to Mutual Funds

April 4, 2005
Fidelity investments’ creation of a separate business unit dedicated to institutional, non-mutual-fund business reflects an interesting and significant trend: 401(k) plan sponsors are again adding collective investment trusts to their plans.

The recent bear market and scandals that hit the mutual fund and insurance industries have caused many companies to review the fees and costs associated with their 401(k) plans. As a result, many are realizing that mutual funds may not be the most cost-
effective option, analysts say.

“The market is a lot tougher today in recognizing the value of savings,” says Pam Hess, defined-contribution investment consultant at Hewitt Associates. “Twenty-five basis points in savings is really exciting again.”

Collective investment trusts, also known as commingled funds, are pooled investments created for institutions. Unlike with mutual funds, in which everyone gets charged roughly the same expense ratios, plan sponsors have more negotiating power when determining the fees for collective investment trusts. The larger the plan, the more negotiating power the company has.

“A lot of companies are moving away from mutual funds toward collective trusts because they are seeing things that are discouraging,” says Don Stone, president of Plan Sponsor Advisors, a Chicago-based retirement plan consultancy. “When you look at a billion-dollar plan and they are paying the same expense ratio as someone with a million-dollar IRA, it doesn’t make sense.” The average expense ratio for a short-term bond commingled fund is 31 basis points, while the average expense ratio of a short-term bond mutual fund is 100 basis points, according to Hewitt Associates.

Furthermore, collective investment trusts do not have the trading issues that mutual funds do, Hess says. As New York Attorney General Eliot Spitzer’s investigation showed, anyone can invest in a mutual fund, and so trading abuses that go on outside of a 401(k) plan can still cause plan participants to lose money. Since collective investment trusts are only managed for those specific plans and are not available to the general public, market timing and other trading abuses tend to not be an issue.

“You aren’t going to have a hedge fund trading into a collective trust,” Hess notes. Mutual fund companies have implemented different redemption fees for their various funds to stop active trading, but in collective investment trusts, the employer can just set limits on what trading the participant does. “If there is a trading issue, the plan sponsor can take care of it,” Hess says.

When 401(k)s were first introduced in the ’80s, collective trusts were quickly surpassed in popularity by mutual funds because they provided daily valuations: Employees could look in the newspapers and check the prices of their funds every day. Also, thanks to mounting marketing and advertising budgets, mutual fund companies had more brand recognition among everyday investors than did the collective trusts.

In the mid-’90s, trust providers began adapting the technology to provide daily valuations. But 401(k) plan sponsors remained hesitant because these prices were not in the newspapers for all their employees to see, says Catherine McBreen, managing director at Spectrem Group. Today, however, people can access prices via the Web, and many plan sponsors are deciding that the cost savings--30-50 basis points--outweigh the value of having prices carried in newsprint.

When a big retail mutual fund player like Fidelity creates a separate business unit for non-mutual-fund business, it means there is a substantial business opportunity, Stone says. He believes that more fund companies will soon follow in response to demand from employers. “More plans sponsors are doing this, and so far we have not heard a single participant complain,” he says.

Jessica Marquez