What to Ask Your Index Manager: SSGA

index funds, 401k, retirement, State Street

And how do they fit in 401k plans?

Over the past decade, investor adoption of index fund-based strategies has soared.

To meet the demand, asset managers have formulated new low-cost offerings, driving the competition up and investment management fees down.

While the influx of index-based solutions provides more choice to investors, it also presents challenges in the selection process—and too often fees become the key criterion for manager and fund selection.

While fees are an important and “simple” metric, they are not the only factor that should be considered.

Heather Apperson

In fact, as fees compress, the other factors that drive benchmark-relative tracking error have increased in importance.

Here, we will focus on three of those alternative factors that index investors should consider:

We will examine three questions pertaining to these areas with the goal of empowering investors to “go beyond the fee” when assessing a current or prospective index manager.

We’ll also highlight to address some of these areas from an equity index management perspective.

Why does performance of an index fund matter?

Delivering index returns is often thought to be a relatively easy undertaking that any manager can accomplish.

However, there are a number of embedded index assumptions that make this task more challenging than meets the eye.

To better understand this concept, let’s take a closer look at five key assumptions and how they play out in the real world. Figure 1 describes several notable index assumptions, the realities and some potential ways a manager might overcome them to reduce tracking error.

Figure 1: 5 Leading index assumptions, realities and opportunities

 Methodology AssumptionsReal World ApplicationPortfolio Management Resolutions
1Trades are frictionless and executed at market on close’ (MOC)A fund incurs both implicit and

explicit costs when trading, resulting in tracking error; trades can be executed outside of MOC Any costs linked to trading lead to differences in performance between the portfolio and the index it tracks

Minimizing trading or turnover,

as well as improving implementation, can minimize costs and tracking error. Ways to minimize costs include:

• Netting client purchases and

redemption via internal crossing

when possible

• Using sophisticated, risk-aware trading strategies, particularly during rebalances

2Like an index, a fund will be 100% invested in securitiesTo accommodate redemptions, a fund must keep some cash on hand, resulting in cash drag due to lack of equity responseFutures can be used as a tool to

equitize either cash or receivables, providing market exposure and minimizing cash drag to the portfolio

3Dividends are received on ex-date and invested immediatelyDividends are not always physically received the same day as the index and are recorded as receivablesFutures can be used as a tool to

equitize either cash or receivables, providing market exposure and minimizing cash drag to the portfolio

4Indices assume a conservative

foreign dividend withholding tax

(DWT) rate

Tax-exempt US investors incur a

lower DWT rate than the index

An investor can reclaim some foreign DWT, resulting in additional income that can help offset negative tracking error relative to the index
5Dividends are the only

income source

A fund may receive income from

other sources not captured by

the index

Securities litigation payments,

securities lending and some

corporate action decisions can be a source of income that can offset negative tracking error and add value to the portfolio

Given these assumptions are known, fund performance will deviate in some way from its respective index. For this reason, it’s pragmatic for a manager to assign expected tolerance bands as a form of performance measurement. This is a critical step in the portfolio construction process, as it helps establish performance expectations.

If the performance differential between the fund and its respective index substantially deviates from its tolerance bands over time, the investor may be incurring an additional cost (i.e., negative tracking error) or potentially taking on unintended risk in the case of significant outperformance.

That said, it’s critical that an index manager finds the right balance of minimizing tracking error and risk when overcoming these variables.

Why is size important?

Index managers often like to boast about the size of their asset base, but what does that really mean to an investor? In index asset management, size is of critical importance. Size supports scalability and provides breadth and depth from a product perspective.

A substantial index asset base may serve as an indicator of an asset manager’s commitment to the index style, helping to pave the way for innovations in process improvements, technology, new product development or enhancements to existing strategies. It can also take form in big-picture industry initiatives like protecting long-term shareholder values through active asset stewardship engagement.

Furthermore, size may potentially help a manager better track a respective index, particularly if the index is broad and has a large number of constituents.

For example, the popular MSCI ACWI ex-US IMI Index, which covers developed ex-US and emerging markets, has more than 6,000 constituents presenting challenges from a replication standpoint in a small fund. So ideally a larger asset base may be able to more easily replicate the index, as it can hold more stocks in the index.

In addition, sizable funds with a diverse client base can often accommodate larger contributions or redemptions. This can potentially lead to less turnover, assuming the manager invests in futures or utilizes an internal crossing network, whereby contra investors’ flows can be netted against one another.

And finally, size can translate into more effective implementation. This is particularly meaningful in the DC arena, which encompasses millions of investors and countless transactions. In this context, a large fund manager may be able to more easily absorb money movement with less impact to fund performance.

In practice, this means a large fund can potentially accept substantial cash contributions without having to immediately buy securities to house the assets.

Instead, managers can buy or sell futures to reduce transactions costs. More importantly, a manager with a large and diverse client base will likely have more contraflows that can be netted against one another, assuming the manager has established a robust internal crossing mechanism or network.

This process can provide substantial savings to plans and participants, often in excess of the management fee of a fund. We take a closer look at crossing in the next section.

What is the most appropriate vehicle for an index fund and why does it matter?

Index funds are offered to US-based institutional investors in several structures, including mutual funds, pooled trusts like collective investment trusts (CITs) or collective trust funds (CTFs), exchange-traded funds and separately managed accounts.

Depending on factors such as the investor’s tax status or legal structure, investment time horizon, liquidity and need for customization, one vehicle may be more suitable than another for certain investors.

For the purposes of this section, we’ll focus on the differences between mutual funds and CITs, which are pooled funds regulated by the US Office of the Comptroller of the Currency and typically available only to tax-exempt entities.

And oftentimes, a CIT structure is the most suitable index vehicle for large-scale tax-exempt entities such as defined contribution plans.

Figure 2: Vehicle characteristics at a glance

 CITMutual Fund
Investor EligibilityERISA (DB & DC) and other tax-exempt entitiesAll
Mandate Size RequirementsInitial investmentSome
Relative Price RangeLow and may incorporate relationship pricingLow to high
Public Availability of

Fund Information

LimitedMinimal limitations
Transaction CostsTypically lowerMedium

Despite almost 50% of defined contribution plans in the US offering CITs on their plan line up, mutual funds remain the primary default index fund vehicle option. Some reasons may include the perception of “portability,” participant familiarity and ability to access publicly available information.

However, CITs offer a number of advantages over a mutual fund. Some of those advantages include:

Figure 3: Internal Crossing—A Powerful Source of Cost Savings & Liquidity

 Total Value5 ($)In-Kind6/Internal Crossing/

Unit Crossing

Estimated

Cost Savings7

US Market Case Study2

(2016–2018)

129.1 billion92.1% of the total0.06% of the total
Non-US Developed Case Study3

(2016–2018)

24.1 billion85.5% of the total0.23% of the total
Emerging Markets Case Study4

(2016–2018)

17.6 billion59.1% of the total0.35% of the total

Note: Availability of internal crossing at State Street Global Advisors may be affected by your asset class, vehicle type, jurisdiction or other factors.

Figure 4: Meaningful CIT Tax Benefits Gained in the MSCI ACWI ex-US IMI Index

Country2018 Dividend

Yield (%)

ERISA CIT

Tax Rate (%)

Mutual Fund

Tax Rate (%)

Weight in

MSCI ACWI

ex-US IMI (%)

Impact (%)
Japan2.2101017.420.039
Australia4.390154.700.031
Canada2.980156.570.029
Germany2.810156.290.026
Switzerland3.180155.140.025
Sweden3.770152.090.012
Netherlands2.770152.350.010
Finland4.040150.750.005
Belgium3.310150.820.004
MSCI ACWI ex-US IMI   460.181

CITs have been used by institutional investors for several decades, but some smaller investors or those primarily in the DC space have been late adopters.

For the reasons described above, many traditional mutual fund investors are rethinking their index fund choice and gaining a better understanding of the benefits that alternative options may provide.

It’s worth noting that not all CITs are the same. There are some subtle differences among CITs offered by different managers. For that reason, investors should discuss onboarding and contracting with their managers, as the process can be more or less straightforward depending on the manager.

An investor should also inquire as to whether the manager has or maintains a crossing program, as well as what historical estimated transaction cost savings they’ve earned in for specific CIT strategies.

Conclusion

Given the attention paid to fees over the past few years, selecting an index manager and vehicle has become somewhat of a “passive” process. Today, fees have settled to record lows and investors are now looking for alternative ways to evaluate index funds.

Performance, size and scale and the index vehicle are meaningful dimensions to incorporate into the due diligence process and will most likely offer a new and fresh perspective on the index marketplace.

Choosing the right index manager matters—and asking better questions will help separate the rigorous from the regular.

Heather Apperson is a Vice President of State Street Global Advisors and a Portfolio Strategist supporting the Global Equity Beta Solutions Group. She is responsible for devising and delivering index equity solutions to institutional clientele.


1 Based on actual client order flow trading activity in the S&P 500® Defined Contribution Commingled Fund.

2 Based on actual client order flow trading activity in the Thrice-Monthly EAFE ERISA Commingled Funds.

3 Based on actual client order flow trading activity in the Thrice-Monthly Emerging Markets ERISA Commingled Funds.

4 For calendar years 2016–2018. It is not known whether similar results have been achieved after 2018.

5 In-kind transfers are redemptions/contributions made via security transfers.

6 This represents estimated average savings across all aggregate trading over the period. These estimates are based on subjective judgments and assumptions and do not reflect the effect of unforeseen economic and market factors on decision-making. There is no guarantee that a particular client transaction will experience the same level of savings. In fact, savings could differ substantially. Any savings is contingent upon other activity taking place on a given transaction day. Had other funds been selected, different results of transaction cost savings may have been achieved. All figures are in USD.

7MSCI Index Data, published ERISA and RIC Tax Rates, as of December 31, 2018.

8 Last calendar lending returns paid to the fund in the State Street US Equities ERISA CIT strategies, as of December 31, 2018.

9 State Street Global Equity Beta Solutions (GEBS), as of December 31, 2018.

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