White Label Funds: A No-Nonsense Design Handbook · WHITE LABEL FUNDS: A NO-NONSENSE DESIGN...

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White Label Funds: A No-Nonsense Design HandbookROD BARE, JAY KLOEPFER, LORI LUCAS, AND JAMES VENERUSO

THE JOURNAL OF RETIREMENT SPRING 2017

ROD BARE

is a senior vice president in the Fund Sponsor Consulting group at Callan Associates in Chicago, [email protected]

JAY KLOEPFER

is an executive vice president and the director of Capital Markets Research at Callan Associates in San Francisco, [email protected]

LORI LUCAS

is an executive vice president and the Defined Contribution practice leader at Callan Associates in Chicago, [email protected]

JAMES VENERUSO

is a vice president and defined contribution consultant in the Fund Sponsor Consulting group at Callan Associates in Summit, [email protected]

White Label Funds: A No-Nonsense Design HandbookROD BARE, JAY KLOEPFER, LORI LUCAS, AND JAMES VENERUSO

The prime directive for plan fidu-ciaries is very simple: Do the best they can for participants. Not the best if they have the time or

interest, but the best, period.This article represents the authors’ view

on “white label” funds, the best way to offer active management in large defined contri-bution (DC) plans to participants who handle their own portfolios. We developed our approach through challenging client projects that provided us with the insights we share in this article.

White label funds are generic invest-ment structures constructed using a specific mix of underlying funds to provide a simple but rich exposure to an asset class. These funds offer many benef its to participants because they are tailored to the objectives of the plan, not the goals of the individual fund managers. But like many aspects of investing, there is no free lunch. White label funds need extra resources and require more effort to unlock their benefits.

In our work, we learned lessons about how to design and package white label funds. This experience has pushed our thinking beyond today’s conventional wisdom of white label funds as a “unitization” of a collection of funds. We believe the use of custom fund structures, with their potential pricing effi-ciencies and upgraded governance structures, is the next breakthrough for f iduciaries of

large DC plans committed to providing their participants with the best solutions.

Finally, we want the reader to remember that white label funds unlock real value under certain circumstances. To be sure, the bulk of this article describes the work required to incorporate white label funds into plans. But this is a worthy endeavor, confirmed each time we see a plan use white label funds to solve a capacity problem with current fund options, shape the choices for participants to a safer range without sacrificing quality, capi-talize on access to a good low-cost defined benefit (DB) plan manager, or correct issues that are the focus of lawsuits. We hope readers find the value to be worth the effort as well.

And to help readers in this effort we have included in the appendix a glossary that defines some of the key subjects we discuss.

BENEFITS AND CONSIDERATIONS

How Are White Label Funds Constructed?

“White label” products, clever off-shoots of efficient manufacturing, are items created by one manufacturing entity to be rebranded and offered by others with dis-tribution resources, often with the end-buyer unaware of the difference. This is very common in groceries, liquor, clothing, and telecommunications—same product but

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WHITE LABEL FUNDS: A NO-NONSENSE DESIGN HANDBOOK SPRING 2017

different marketing, designed to connect with different pockets of buyers.

White label funds are custom investment options for DC plans that contain one or more branded invest-ment strategies predominantly from the same major asset class but that are labeled as generic asset-class funds. This generic, intuitive fund labeling is designed to help the participant easily understand the fund’s role in a portfolio. For example, consider two funds: a white label “small cap fund” versus “the ACME Vigilant Fund.” Both can have very similar strategies, but it’s not apparent where the “Vigilant” fund fits in a portfolio. White label funds also help plan administrators swap out underperforming funds without putting brand-loyal participants through the mental stress of a fund removal even if it is underperforming.

In terms of f lexibility, white label funds can be very fiduciary-friendly investment options. The secu-rity selection methodologies inside a white label fund can be active, passive, or a mix of both. The internal vehicle structures can include mutual funds, collective trusts, or separate accounts. Plan fiduciaries are respon-sible for selecting the fund managers and allocating assets to them, as well as the necessary disclosure and moni-toring duties typically involved with a plan’s investment options. We see these funds as high-quality but safe-to-handle building blocks for those who wish to assemble their own retirement portfolios.

Why Use Them?

There are several benefits to white label invest-ment structures:

They provide scalable capacity. White label funds gained popularity in very large DC plans when active manager capacity constraints forced the sponsors to offer several very similar funds on the stand-alone menu. Not only was this awkward and confusing for participants, but fund proliferation also frequently became an administrative burden. One properly engineered white label fund can scale beyond the capacity constraints of a single manager. Many plan sponsors also see white label funds as an opportunity to use their DB plan managers in their DC plans to extend the plan sponsor’s due diligence investment in these managers and secure volume pricing discounts.

They can blend a range of security selection methodologies. White label funds can be constructed

from a mix of passive and active options and can use hybrid security selection methodologies such as enhanced index or smart beta products. This f lexibility lets plan fiduciaries refine an investment in active management to fit the plan’s investment objectives and expectations for excess return and risk.

They make it easier to replace underperform ing asset managers. Committees often say they would like to remove a popular but underperforming “brand-name” fund but fear a participant backlash. White label funds provide a helpful disconnect from this brand “lock-in.” The plan fiduciary can also arguably replace an underlying manager without engaging in a 30- to 90-day participant notice event, since the white label fund is the investment vehicle for the participants, not the funds within the structure. (Fund communications would be updated to disclose any new underlying managers or allocation changes.) Track records, enrollment materials, and websites that discuss options at the white label fund level remain fairly stable while the subadvisors are upgraded and the factsheet disclosures are updated.

They let fiduciaries control fees. Plan fiduciaries have an obligation to hold fees to reasonable levels, as they are reminded by a growing list of lawsuits. A white label fund can put fee control back into the fiduciaries’ hands by letting the fiduciary determine the number of low-cost index funds used inside the fund. More efficient asset classes do not offer the same return on investment in alpha that less-efficient asset classes represent. Some retirement committees would like to offer a white label fund comprised of a core passive fund position with a couple of satellite positions in concentrated style strategies. These concentrated style strategies may be too expensive or too risky as stand-alone options on a DC menu but may add value to a single white label fund. White label funds are often the building blocks for multi-asset-class solutions such as target date funds. Shifting the structure of one building block to produce a lower fee may provide leeway for strategies in other asset class building blocks with higher alpha prospects but also higher costs.

They fix several behavioral finance issues for participants. Academic research shows that human beings have certain, often unhelpful, behavioral biases when presented with choices, and fewer options are often easier to navigate than many. So, for example, participants are better served with the option for one

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white label small/midcap equity fund, incorporating a handful of complementary investment strategies, rather than a set of individual small and midcap funds. At the same time, the white label fund automatically handles rebalancing of manager exposures for participants through the use of standing instructions with the plan’s operational service provider, an important task often neglected by participants. This structure also eliminates unhelpful performance chasing, saving participants from another thorny behavioral bias. White label funds also help solve two bedeviling “brand” issues. First, they eliminate concerns that participants will be unhappy if a popular brand-name fund is removed from the lineup. The funds also solve the marketing confusion stemming from brand names that do not always make clear the fund’s investment strategy. Clear labeling always trumps marketing when it comes to helping a participant fund retirement.

What Are the Considerations?

White label funds can offer tremendous value to participants, but unlocking the benefits requires plan fiduciaries to take on additional responsibilities:

Up-front education and planning. Plan fidu-ciaries need to understand and take into account complex-ities around setting objectives in a fund-of-funds environment for returns and risk; factor exposure considerations; technical issues arising with rebalancing; trading process details; and liquidity provisions for participant f lows.

Liability for the decisions inside. Picking the managers for a white label fund and deciding the percentage allocation of fund assets to each is a fiduciary decision. Fund structure decisions require a documented f iduciary process like other plan responsibilities. This guide outlines how plan f iduciaries can work through this fund structuring process in a constructive, defensible manner.

Operational requirements. Unitizing a group of managers requires additional services from the plan’s recordkeeper and trust/custodian, and the sponsor has to design, implement, and monitor the white label fund. It is important that the plan has the resources for this work.

Participant communications. Participants need education on what the structure is, why it was implemented, and who is managing it. Even something as simple as

fund fact sheets may require additional input from the plan sponsor.

Knowing when to seek help. Plan fiduciaries are increasingly seeing a benefit to recruiting their service providers as partners to help shoulder some of these responsibilities. There are ways to structure the white label vehicle to add two or three additional layers of fiduciary protection.

WHO SHOULD USE THEM?

White label funds are for DC plans that make active asset management available to participants on the investment menu. Plans that offer index funds exclu-sively do not need them.

In terms of size, f iduciaries for DC plans with assets over $500 million typically can f ind the scale to justify the expense of fund unitization, depending on the asset class. Smaller DC plans with service pro-viders equipped to offer less-expensive model port-folio accounting can also consider white label fund structures. In any case, it will be important for the plan sponsor to have adequate resources—internal and external—to properly manage the white label fund and all its ancillary needs.

While there are exceptions, Exhibit 1 illustrates candidates for white label funds.

FUND GOVERNANCE

Here are key governance decisions plan fiduciaries should keep in mind:

• Who will have discretion over the allocation of assets among the managers inside? There needs to be a documented process for how the allocation decisions are made.

• Does the committee have the proper skills and resources? If the retirement committee is the fidu-ciary for the white label funds, does it, for example, know how to audit a transition manager?

• Does the committee have the mental discipline to compete with commercial asset managers? We have found some committees are surprised to realize their new white label funds are, in the eyes of participants, competing against other major asset management f irm products whose perfor-mance can be reviewed on the Internet. As a result,

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fiduciaries will need to reaffirm the cost, outcome, and administrative benefits of white label funds over branded fund choices.

• White label funds need to grow to achieve econo-mies of scale. If the white label funds are not part of the plan’s qualified default investment alternative (QDIA), or assets are not mapped into the funds upon creation, then asset growth will be slow and structural expenses will not be adequately covered for some time.

FUND STRUCTURING

We will focus on white label funds that reside in the Tier II portion of a DC fund lineup, the core options from which participants can assemble their own invest-ment portfolios (Exhibit 2).

The goal for Tier II is to offer a diversified invest-ment mix that spans the risk–return spectrum and gives do-it-yourself participants the opportunity to diversify their retirement portfolios. The Tier II options should offer the choice of investment strategies that avoid exces-sive risk, have a prudent degree of diversification, and provide acceptable performance.

One key benefit to using white label funds is the ability to simplify the fund lineup, reducing an array of individual manager options to a handful of thought-fully designed asset class building blocks. How far can a

plan move toward simplification? The simplest structure could include just three options: capital preservation, fixed income, and global equity. But behavioral finance and the related principles of choice architecture suggest that such a streamlined menu may lead to underallo-cation to equity assets, should the participant allocate assets evenly to the three options. We believe the stand-alone DC plan menu below strikes a balance between a) access to diversification options and b) the prudence of anticipating the frequently observed “user error” of participants who spread their assets evenly across a menu of investment options:

1. Capital preservation2. Fixed income3. Diversified real assets1

4. Large cap U.S. stocks5. Broad non-U.S. stocks6. Small/mid cap U.S. stocks

With this focus on active management, the design of each asset class fund—the appropriate blend of styles, strategies, and managers—determines the size and sources of active management value added. The asset class design, or manager structure, must ultimately set expectations for performance relative to a passive option and address excess return, tracking error, fees, and the complexity of managing and monitoring the fund.

E X H I B I T 1White Label Fund Decision Tree

Source: Authors’ model.

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We would propose four guiding principles in designing white label funds:

1. Purpose: The starting place in white label fund design is that the fund should invest in the broad market. Deviations are warranted only where there are opportunities to add value.

2. Strategy: Passive management should be used in efficient markets to diversify exposure, reduce cost, and increase liquidity. Active management is only justified in markets where the expected alpha suff iciently exceeds costs. A mix of passive and active management can be used to build portfolios to meet excess return, tracking error, and fee goals.

3. Simplicity: Enough managers should be used to cover all areas of the market and diversify relation-ships without overlapping mandates. Additional managers in the same style add little marginal value to the overall plan, complicate monitoring, and increase fees.

4. Implementation: Be mindful of the asset size, fees, vehicle, liquidity, and rebalancing require-ments for each underlying manager.

We will now delve into the creation of white label funds for specific mandates. For this article, we illustrate what we believe is a reasonable structure for a non-U.S. equity white label fund.

But first, a quick caveat. We intend our white label fund structures to be starting points for a plan fiduciary’s fund design work. We acknowledge that adjustments to these structures will be a natural part of what is really an

iterative design process. For example, the use of a favored manager for one exposure may tilt the white label fund’s exposure to such a degree that the fund allocation per-centages need to be adjusted to compensate.

Non-U.S. Equity

The role of non-U.S. equity in a DC plan par-ticipant’s portfolio is to provide diversification for U.S. stocks in the pursuit of capital appreciation. Non-U.S. equity markets supply half of the global equity market’s capitalization, divided among developed and emerging markets. We suggest that a plan offer one broad, diversi-fied non-U.S. equity option, with exposure to all market segments:

• Large and small cap• Developed and emerging markets• Growth and value

The policy benchmark should incorporate:

• The full opportunity set of the entire non-U.S. equity market

• Liquid and investable vehicles• A transparent composition and valuation

The MSCI All Country World Index ex USA (MSCI ACWI ex USA) meets most of these require-ments and is frequently used as the policy benchmark for broad non-U.S. equity, as it includes emerging markets.

E X H I B I T 2Three-Tiered Investment Structure


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However, MSCI ACWI ex USA does not include the small cap market segment; the Investable Market Index (IMI) version of the index does and is emerging as the preferred index.

Active management has historically added value in all areas of international investing, although more recent experience suggests that active management has had trouble adding value in the large cap sector of developed markets. Active managers continue to dem-onstrate the ability to exceed the benchmark in small cap and emerging markets. Unconstrained, broad man-dates allow managers to seek alpha in all segments of the equity market—all cap, global, and MSCI ACWI ex USA. Passive management can play a key role in a broad non-U.S. equity portfolio, providing liquid and diversified exposure that can control costs, manage risk, and provide an anchor against which active managers can pursue alpha.

We recommend these structure rules for a non-U.S. equity option for a DC plan:

1. We have a preference for multimanager structures for a variety of investment and operational reasons.

2. Given the research on relative market inefficien-cies in non-U.S. equity pricing, we generally favor active management in this space, but we believe there is a role for a blended approach that employs some passive exposure to provide cheap and broad diversif ication to manage the overall risk of the portfolio as well as the expense ratio.

3. Emerging market exposure is the single greatest determinant of relative performance of non-U.S. equity products. The evidence supporting a stra-tegic overweight to emerging markets compared with capitalization weighting, however, is not suff iciently compelling, given the severity and length of the relative performance cycles between emerging and developed markets. Because of the importance of the index in the evaluation of rela-tive performance, our default structure should maintain a strategic weight to emerging markets close to the MSCI ACWI ex USA benchmark.

4. Emerging markets are complex, heterogeneous, and somewhat structurally inefficient. They are generally more liquid than the developed small cap markets and therefore allow for greater scal-ability of products, which in turn allows managers to support the infrastructure necessary to deal with

the complexity of the markets while still charging a palatable fee to investors. The average actively managed product has generally outperformed the index net of fees, further supporting the case for active management.

5. Emerging markets can be implemented either through a dedicated, stand-alone emerging market portfolio, or as part of an ACWI ex USA portfolio. The ACWI ex USA benchmark contains a market-cap weight to emerging markets. The advantage of the stand-alone approach is that the emerging market investments in a dedicated emerging port-folio tend to be more diversified across countries, industries, and capitalization. Bottom-up stock selection tends to be the primary driver of outper-formance in these portfolios. The advantage of the ACWI ex USA approach is that managers have the ability to allocate between developed and emerging markets based on relative valuations. The emerging market exposures in ACWI ex USA portfolios tend to be more concentrated in larger names and larger countries. Given the merits of each approach, we believe it may be reasonable to employ both in a white label structure; i.e., combine ACWI ex USA managers and emerging market managers. One note for those who implement with both types of strategies: Controlling the portfolio’s emerging market exposure so that it ref lects the broad non-U.S. equity opportunity set will be more compli-cated given the lack of control over the emerging market exposure inside the blended strategy itself. The country weights across developed non-U.S. markets and emerging markets will have to be bal-anced through the careful setting of mandates to various regions.

6. Given the somewhat stronger case for active man-agement in the emerging markets than in the developed markets, we recommend that any pas-sive management in the structure should focus on the developed markets.

7. Reasonably strong arguments (theoretical and empirical) can be made for a persistent small cap premium in non-U.S. developed markets. Emerging markets and developed markets undergo prolonged and severe periods in which one underperforms the other, which makes holding onto a strategic overweight to emerging markets too painful for many investors to maintain, even if the long-term

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data suggest higher rates of return on average in emerging markets. Similar data also suggest a pre-mium is available for developed markets small cap over developed large cap. In this case, the relative performance cycle between developed small cap and developed large cap is not as severe or persistent, and therefore a tilt toward international small cap may be easier to maintain when small cap is out of favor. Thus, we believe it may be reasonable to maintain a modest strategic overweight to developed non-U.S. small cap in a non-U.S. equity structure.

8. Like emerging markets, non-U.S. small cap mar-kets are complex, illiquid, heterogeneous, and somewhat structurally ineff icient. While these characteristics would typically suggest the use of active management, there are some challenges unique to this asset class that make us hesitant to recommend a fundamental manager as the sole non-U.S. small cap fund in a white label struc-ture. The MSCI Small Cap index includes more than 4,000 stocks across 23 different countries. The size and heterogeneity of this market make it very difficult for a single fundamental manager to create a consistent information advantage across all of these securities. This problem is compounded by the lack of scalability of concentrated products in this space (owing to liquidity constraints), their comparatively high fees, and high tracking error. We suggest caution. A quantitative strategy may provide the exposure desired while minimizing current market product limitations.

These principles for a non-U.S. equity structure can translate into a “clean-sheet” structure consisting of a 10% strategic weight to developed markets small cap, a 10% allocation to well-diversif ied stand-alone emerging markets, and a 20% allocation to an EAFE index fund (Exhibit 3), to complement a 60% core allo-cation to an active ACWI ex USA mandate.

This example asset allocation serves as a starting point in developing a white label international equity fund, which will be customized to serve individual DC plan needs.

FUND IMPLEMENTATION

While the underlying makeup of a multimanager fund deserves careful attention, a crucial step is deciding

how to set the fund up and make it operational. Solu-tions range from utilizing a recordkeeper’s platform to build model portfolios, to having the trust/custody provider unitize the funds to create custom accounts. Newer approaches involve creating a customized col-lective trust or a private mutual fund.

The operational considerations for white label funds often represent the most signif icant hurdle to implementation. Each approach varies in the level of operational complexity and cost.

Model Portfolios

A model portfolio is a collection of holdings that ref lect a model allocation designed to achieve a partic-ular investment objective. In a model portfolio, partici-pant dollars are allocated to underlying managers based on predetermined weightings. The “model portfolio” is never unitized. Rather, participant dollars purchase shares of the underlying funds.

Model portfolios do not come without issues, however. Recordkeepers vary widely in their capabili-ties. In many instances, a fund offered within a model portfolio must also be offered on the plan menu due to recordkeeping platform limitations. Therefore, highly concentrated managers that are carefully used in a model allocation could be misused on a standalone basis.

E X H I B I T 3Example Asset Allocation inside a White Label Non-U.S. Equity Fund


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For example, a standalone emerging market manager that holds only a few underlying securities could be used in a controlled manner within a model portfolio, but if offered on a standalone basis could prove too volatile and tempt participants to chase performance. Because the funds used within the model portfolio are often standalone investment alternatives as well, removal of a fund requires participant notifications under ERISA, which can take up to 90 days. In addition, when funds are offered in the model portfolio, they will gener-ally show up on statements ref lecting balances in the underlying funds as well as the model portfolio, which can potentially create participant confusion. An ideal implementation of the model portfolio would keep the funds used in the models from being offered on a standalone basis and include reporting aggregated at the model portfolio level. Some recordkeepers do have this capability.

Unitized Separate Accounts

In this approach, underlying fund allocations (mutual funds, collective trusts, or other separate accounts) are combined for ease of administration into a new separate account structure. This new separate account is divided into units, or “unitized,” for plan use. Participants buy units of this new separate account rather than the units of each underlying fund. Setting up a unitized white label fund requires working with a set of service providers to ensure that a range of initial and ongoing operational needs are addressed such as fee accruals and rebalancing.

When considering a unitized fund, sponsors must first identify whether the current providers can imple-ment the desired structure in a cost-effective, efficient manner. A plan sponsor can either use an external trust/custody provider or the recordkeeper’s internal trust/custody services. Not all recordkeepers can provide these services, however, and there is a wide variation in capa-bilities among recordkeepers and custodians. Further, not all recordkeepers are open to working with outside custodians or they only work with certain third parties. It is important that plan sponsors understand up-front any limitations among the plan’s service providers so that alternatives can be evaluated.

Entering into an arrangement. In most cases, the plan trustee will also serve as the custodian. The trustee handles the movement of money (contributions, distributions, etc.) as well as the safekeeping of assets. The custodian is often the party that strikes the net asset value (NAV) and handles the underlying accounting and valuation. In some instances, the recordkeeper handles these functions; however, as with model portfolios, capabilities vary widely. In other instances, an external trustee and custodian are brought in. In these arrangements, the external trustee/custodian will administer trust and custody for the entire plan. Only in very rare instances will a provider serve as trustee or custodian for only part of a DC plan. Such an arrangement can lead to piecemeal reporting and piecemeal compliance.

The entity serving as the trustee/custodian holds the DC plan assets in a master trust (as trustee) and handles the underlying fund accounting and NAV calculation for the multimanager fund. In some cases, another party serves as the transfer agent responsible for rebalancing and trading activity. In other instances, these activities are directed to the underlying managers by the recordkeeper. It is crucial to delineate/make clear the roles and responsibilities of each party so that all are aware of their role in the unitized fund operations.

What occurs daily in a unitized structure. The daily operation of the multimanager fund involves various steps (Exhibit 5):

1. Often the first step is to process transactions from the previous day. These are often participant-directed cash f lows. The data move from the recordkeeper to the custodian, and then the cus-todian confirms the move with the recordkeeper.

E X H I B I T 4Model Portfolios


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2. After transmission of participant-directed transfers, any cash transfers between underlying managers in a portfolio within a white label fund can occur.

3. Any dividend, income, or expense accruals are processed.

4. During the day, the custodian will receive any trade confirmations from the underlying invest-ment managers. The custodian performs a recon-ciliation of these transactions and the ending share balances for the underlying funds.

5. Once markets close, there is a freeze on record-keeper and participant transactions. The custodian receives a transmission with security pricing. The trust system updates values to ref lect the new prices. At this point, there is a reconciliation process to double-check the pricing of the underlying funds.

6. Having verif ied and locked the pricing on the underlying funds, the NAV is calculated by the

custodian and transmitted (along with the total units of the white label fund) to the recordkeeper. The recordkeeper will often certify the total units of the white label fund.

At this point, activity for the day is complete. The crucial point about the process is the presence of checks and balances (in the form of reconciliation and verifi-cation) between the various parties whenever data are transmitted and processed. In fact, one of the major strengths of hiring an external trustee/custodian is the checks and balances this makes possible, which may not always occur when one entity controls the entire process.

With a high-level understanding of the daily pro-cesses in place, some commonly overlooked operational requirements include:

Reconciliation. In the reconciliation process, cus-todians compare their value with that of an index or

E X H I B I T 5Data Flow for Unitized Separate Accounts


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a value supplied by the underlying manager. If the discrepancy exceeds a predetermined amount, the root of the discrepancy is explored. Often the discrepancy in valuation can be due to timing (when securities were marked-to-market) or when dividends are received, or whether receivables are treated as cash. Prior to going live, a plan sponsor should understand the thresholds that can trigger the reconciliation process and how discrepancies will be resolved.

404(a)(5) compliance. The 404(a)(5) disclosures are required under Employee Retirement Income Security Act (ERISA) and provide participants with information on plan options. Contained in the disclosures is not only investment-related information (performance) but also fee information. While an expense ratio for a standalone investment option is fairly straightforward, the calculation of an expense ratio for a multimanager fund must take into consideration the actual day-to-day historical weightings for the fund and then calculate the actual weighted expense ratio. Likewise, any fees that are included in the expense ratio (e.g., recordkeeping expenses) must be included. Given the degree of complexity involved in this calculation, many custodians charge a separate fee for 404(a)(5) reporting.

The turnover calculation is also required on 404(a)(5) disclosures. While turnover presents an intuitive measure of the underlying “churn” (and an idea of how churn is eating into returns via transaction cost) the measure gets somewhat murkier when instituted for a multimanager fund. The Securities and Exchange Commission gives detailed instructions on the measure in Form N-1A, but this guidance assumes one underlying manager. As a result, the measure of turnover in a multimanager setup lacks consistency and, by extension, meaning. Anecdot-ally, measures of turnover used in practice range from weighted turnover of the portfolios of the underlying managers to participant-driven turnover in the fund. In many instances, plan sponsors utilize turnover rep-resenting shifts in the underlying managers.

Fund fact sheets. In addition to the 404(a)(5) disclosures, fund fact sheets represent another commonly overlooked operational hurdle that can bedevil implementation. As a first step, a plan sponsor should identify which party will be responsible, which can vary from the custodian, trustee, recordkeeper, or third-party providers such as consultants, depending on capabilities. Typically, fact sheet production can take anywhere from 30 to 90 days after the end of the quarter, dictated by

the wait to receive the largest stock holdings in each of the underlying total portfolios and calculating the overall expense and/or turnover ratios. For this reason, sponsors should consult with a trustee to understand the degree of transparency possible into the underlying components of the white label fund. Transparency at the trust/custody level can help expedite the plan’s periodic disclosure update process by eliminating the need to rely on the manager to supply this information. Prior to implementation of a schedule, a recordkeeper should make sure the timing is consistent with guidelines for posting material on the participant website. Fact sheets are another area where cost can creep in, so any implementation should take the cost of fact sheet production into consideration.

Track records. The issue of track records relates closely to fund facts and 404(a)(5) disclosures. Both disclosures and fund fact sheets display a fund’s track record. As unitized multimanager funds are new, no actual live track record can be shown, which can slow their acceptance by participants.

Underlying vehicle selection. Within a unitized structure, various types of vehicles can be utilized. A plan sponsor can mix-and-match from collective trusts, mutual funds, and separate accounts. Although separate accounts may offer the lowest fees, they typically carry more operational difficulties. For example, when engaging a manager to set up a separate account, a plan sponsor and the manager must agree on the underlying investment guidelines. The separate account will also incur underlying trading costs, which depending upon turnover can be sizable. For each underlying trade within the separate account, there are two components of cost: the brokerage commission paid to execute the trade and the fee paid to the custodian for trade settlement. In certain asset classes such as non-U.S. equity, where there are currency trades in addition to underlying security trades, the transaction cost report can be lengthy. In one instance, a client with an underlying non-U.S. equity separate account receives a detailed list of transaction costs that is often in excess of 100 pages! Keep in mind too that the underlying separate account will also need to be unitized. Therefore, there will be two layers of unitization: at the underlying fund level as well as at the larger multimanager level.

The number of layers also plays a role in the audit process. By utilizing underlying collective investment trusts (CITs) or mutual funds, the plan sponsor can

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eliminate an extra layer in the audit process. When using underlying separate accounts, plan sponsors bear responsibility for the audit process. When wrapping an underlying separate account into a multimanager unit-ized separate account, there are now two layers to the audit process: the underlying separate account and the multimanager separate account. The fact that CITs and mutual funds are independently audited can eliminate one layer in the audit process.

When considering the underlying vehicles, one factor is whether the added difficulties and operational cost of utilizing underlying separate accounts is made up for by the decrease in investment management cost and the benefit of having control over the investment guidelines and access to managers that pooled vehicles may not offer.

Rebalancing. Rebalancing is another area where approaches often differ. The common refrain that plan service provider capabilities differ widely is applicable to rebalancing as well. In some instances, the custodian will communicate directly with the underlying managers to execute trades to rebalance the portfolio. Because not all custodians have expertise in rebalancing, this task may involve another firm (transfer agent) acting in concert with the custodian to rebalance in an efficient manner to limit underlying trading cost. In other instances, the recordkeeper or even the plan sponsor bears responsibility

for communicating with the managers for executing trades to bring the portfolio back to policy weight.

In most instances, the plan sponsor will provide the party responsible for rebalancing with a standing letter of direction as regards rebalancing the portfolio. Often providers will be able to use existing cash f lows to bring the portfolio back to policy weight rather than force a manager to execute sells. For managers who are new to the DC world, the presence of unexpected cash f lows often represents a challenge. For this reason, when vet-ting managers, the f lexibility to deal with unanticipated cash f lows should be of paramount importance.

The Final Frontier of Customization—Collective Trusts and Mutual Funds

Customized collective trusts or mutual funds repre-sent the final frontier of multimanager implementation. A custom mutual fund or CIT is a pooled vehicle tailored for a specific plan. For plan sponsors who have not only the scale but also the internal resources, a custom mutual fund or collective trust can be attractive. A custom mutual fund could be a good fit for plans that are otherwise restricted from investing in separate accounts or CITs (e.g., 403(b) plans). A custom collective trust may appeal to a group of employers in the same industry or activity that cannot otherwise pool resources in a multiple-employer plan framework. By offering a unified lineup of collective trusts, the employers can pool investment resources and achieve scale. Three main parties play a role in handling custom collective trusts: the sponsoring trustee, invest-ment manager(s), and valuation agent (Exhibit 6).

COMMUNICATIONS WITH PARTICIPANTS

Impact

Custom funds require customized communica-tion, including customized naming, fund fact sheets, and educational materials. However, such considerations are often an afterthought. Indeed, behavioral finance shows us how important such communication can be. In one experiment, researchers found that managers with for-eign-sounding names experienced 10% lower annual fund f lows, even though their performance was similar to funds of managers with “typical” American names. Managers with foreign-sounding names also experience lower appreciation in f lows following good performance

Getting to Know the Actors (Exhibit 5)

Recordkeeper—Maintains participant-level records, processes underlying participant transact ionsCustodian—Fund valuation and accountingTrustee—Safe-keeping of plan assetsManager—The investment managers implement a given strategy. The underlying vehicles can be col-lective trusts, separate accounts, or mutual funds. Perhaps the largest challenge for managers is the unanticipated cash f lows that are part and parcel of the daily liquid DC world. For this reason, man-agers must be nimble at putting cash to work while maintaining liquidity.Transfer Agent—In some cases there is an external transfer agent who handles the rebalancing of the underlying funds as well as the trading activity if there are underlying separate accounts.

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and greater decline in f lows following poor performance (Kumar, Niessen-Ruenzi, and Spalt [2015]).

Naming

Common approaches to naming white label funds are:

• Incorporating the name of the sponsoring company—e.g., XYZ Equity Fund. If the relation-ship between employer and employee is positive or even paternalistic, this strategy can leverage the mutual goodwill and help workers gain comfort with the DC plan investments (known as “famil-iarity bias”). On the other hand, if investment decisions within the white label structure have been delegated to a third party, naming the fund after the sponsoring corporation may suggest a higher level of involvement in the fiduciary deci-sion making than exists. At companies with less-than-cordial worker relations, such labeling could work against the white label fund’s utilization.

• Focusing on salient properties of the fund—e.g., Growth Fund or Income Fund. While it may sound reasonable to focus on the factors that drive an investment’s performance, an exhaustive search has revealed no research showing that DC participants respond to or even understand objective-oriented fund names. Indeed, such naming could even be confusing if workers take them literally: “Of course I want my funds to grow” versus “Why do I need income in my 401(k), I’m not ready to retire?”

A good rule of thumb is to keep the naming con-vention as simple and descriptive as possible: Capital Pres-ervation Fund, Bond Fund, Large Company Stock Fund, International Company Stock Fund, Small Company Stock Fund, etc. Such a generic approach can readily tie into education efforts and even modeling approaches.

Fund Fact Sheets

Track records can be an issue for fund fact sheets and other communications (Exhibit 7). Many recordkeepers will not permit hypothetical performance track records on their websites, even on third-party fund fact sheets. In some cases, plan sponsors have resorted to placing such information on their company intranet sites instead.

In designing customized fund fact sheets, the key will be to focus on aggregate white label fund perfor-mance while providing adequate information about the underlying component funds. One of the beauties of white label funds is that they can help prevent unproductive participant behavior such as chasing returns of volatile funds (i.e., emerging market equity). As such, it can be beneficial to bundle “high-octane” fund performance into the overall total return and risk of the white label fund as illustrated in Exhibit 7. At the same time, for the sake of complete transparency, the fund fact sheet could provide extra detail so participants could link to additional infor-mation about the underlying funds in the white label fund.

Guidance and Advice

Plan sponsors should not forget the challenges of incorporating white label funds into guidance, advice, and managed account products. While many service providers will model any designated investment fund in a plan—including white label funds—such modeling may require extra input from the plan sponsor such as

E X H I B I T 6The Roles of the Three Parties in a Custom Collective Trust


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providing a representative performance history, ongoing rebalancing information, etc.

CONCLUSION

DC plans are replacing DB plans as the cornerstone of retirement funding. As these plans grow larger, utilize more institutional vehicles, and continue their focus on fees, we believe that white label funds have a natural role in that evolution.

The best candidates for white label funds are plans with enough assets to cover the additional costs and staff with the resources and expertise to manage these

structures. In terms of covering the additional costs, it is important to be mindful of today’s shifting cash f low trends. For most plans, the default investment option, such as the target date fund series, receives the majority of the participant cash f lows thanks to automatic enroll-ments and plan re-enrollments. Some plan sponsors use their white label funds as building blocks inside a custom target date structure so the fees for the stand-alone funds benefit as well from asset growth.

The good news is that white label funds can unlock several benefits for DC plans including scalable capacity in certain asset classes, access to best-of-breed active management, reduced user error among participants

E X H I B I T 7White Label Fund Performance: Fact Sheet Illustration


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confused by too much choice, and administrative effi-ciencies. The control that white label fund structures gives plan fiduciaries is increasingly important in today’s environment.

There are some important operational consider-ations, such as the capabilities and limitations of the service providers for the plan and some up-front design decisions.

Participant communications are also important for white label funds. First, key disclosures must be pro-duced and distributed for custom funds, the same as for commercial funds. Second, it is helpful to clearly com-municate fund roles and expectations up-front so that participants start off on the right foot.

This structuring guide provides a set of principles designed to shape the construction of each asset class fund (Exhibit 8). This guide can also help a plan design alternative options should a “clean sheet” approach not be possible.

A P P E N D I X

GLOSSARY OF TERMS

“Clean sheet” structure

A new structure, created without reference to a previous structure. The “clean sheet” structure has no obligation to mimic other structures or to use investment funds that may have been previously utilized.

Model portfolio

A portfolio that is assembled by simply purchasing the underlying funds at a set of prescribed or “model” weights. It oper-ates like a unitized fund in many ways, but there is no NAV struck.

E X H I B I T 8White Label Candidate Checklist


Rebalancing The process of periodically moving port-folio assets to other asset classes to match policy asset allocations for those asset classes.

Relative per-formance cycle

A length of time whereby we can observe how one investment performs against a pre-determined benchmark or group of funds.

Stand-alone fund

A fund available to participants for invest-ment in a DC plan. This fund stands by itself; it is not inside another fund.

Unitized sep-arate account

A separate account is a basket of securities purchased and managed by a professional institutional money manager using the assets of a single trust or investor. This account is then unitized to facilitate the ownership and accounting of smaller per-centages of the separate account.

Unitizing Taking one asset amount, such as $100, and creating smaller units of it so inves-tors can buy or sell smaller amounts of the asset. For example, creating 10 units to represent the $100 asset, so investors can transact in smaller units of $10.

White label When a product manufactured by a company with an existing brand name is renamed and offered by other firms to reach new users for the product. White label funds are generic investment struc-tures built with a mix of underlying funds to offer a simple but rich exposure to an asset class.

ENDNOTE

1Diversified real assets should be evaluated on a case-by-case basis and then customized for the purpose identified by the plan sponsor.

REFERENCE

Kumar, A., A. Niessen-Ruenzi, and O.G. Spalt. “What’s in a Name? Mutual Fund Flows When Managers Have Foreign-Sounding Names.” The Review of Financial Studies, Vol. 28, No. 8 (2015), pp. 2281-2321.

To order reprints of this article, please contact Dewey Palmieri at [email protected] or 212-224-3675.

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