Morningstar - Q3 2020 - 13

Investors noticed that, forcing load-fund sponsors
to respond, or lose business.
Nonplussed

Product management was up to the task. The
major load-fund companies promptly launched
"government-plus" funds, which sold call
options on long Treasuries, then distributed the
options proceeds. Investors initially believed that
these funds provided a free lunch, but they
eventually realized that the extra "yield" consisted
not of actual income, but instead of shortterm capital gains. They also began to understand
that government-plus funds inevitably eroded
their net asset values, because such funds
retained all their capital losses but not all their
capital gains.

premium-coupon mortgages, which (you guessed
it) pay higher current yields, but at the
drawback of (you guessed it again) gradually
depleting the fund's capital base.
The cost difference restricted the portfolio
manager's motion. Had the two funds been
structured as clones, the load fund would
have posted a subpar yield (as well as consistently
and obviously posting lower total returns
than Vanguard's fund, because of the additional
expense-ratio ballast). Marketing considerations
prohibited that path. Therefore, the manager
muddied the waters-and boosted yield-
by adopting an idiosyncratic, and eventually
unsuccessful, strategy.

How to Improve
Retirement Plans for
Teachers
One simple CIT
fix would bring down
investment costs.
POLICY

Aron Szapiro

A Fate to Be Avoided

Shortly thereafter, government-plus funds went
from being the industry's top-selling category
to being completely, utterly extinct. Every single
government-plus fund changed its charter or was
merged out of existence. The pluses, it turned
out, were minuses. When portfolio managers did
more, they delivered less.
This pattern was repeated, many times.
"Enhanced-index funds" were created and then
extinguished. Tactical-allocation funds arrived after
October 1987, disappeared, returned after
the New Era's collapse and the 2008 financial
crash, then vanished once again. Do you
wish to own an "American government bond"
fund that supplements its Treasury positions
with Mexican and Argentinian paper? Probably
not. If so, though, you are out of luck. Such
funds were decommissioned a few years after
being created.
Another example: In the early 1990s,
one investment manager subadvised for two
government-mortgage funds. One fund was
Vanguard's and was cheap, while the
other was for a load-fund company and was
expensive. The two portfolios were radically
different. The Vanguard fund's holdings
were conventional. The other fund's investments
were not, consisting almost exclusively of

Although few today recall the details of these
load-fund flubs, they were powerfully important.
They taught a generation's worth of financial
advisors to distrust complex investment strategies
and to appreciate the merits of the simpler no-load
funds that they had long marketed against.
The industry's shift from selling commission-based
investments to charging an advice fee wasn't
primarily driven by product features, but it was
assisted by them.
The challenge for today's active managers is how
to avoid becoming the next version of load
funds. They face a similar difficulty in that their
extra costs prevent them from confronting
index funds directly. Instead, they must define new
investment spaces; convince the marketplace
that these new spaces are somehow superior
to the established paths; and (critically) prove their
theses with their performances. All without
damaging their collective reputations by inventing
fund categories that are not worse than the
ones they intend to replace.
That's a tall order. It may be achievable, but history
suggests that would not be the way to bet. K
John Rekenthaler is a vice president with Morningstar
Research Services. He is quick to point out that the views
expressed in Ivory Towers are his own.

A bipartisan group of U.S. House members1 have
introduced a bill-the Public Service Retirement
Fairness Act-that would allow 403(b) plans to
invest in collective investment trusts,
or CITs. These 403(b) plans are like private-sector
401(k) plans, but they are for teachers and
other public servants, as well as some churches
and nonprofits. Such a change could help
introduce low-cost options to plans that have been
riddled with high-cost offerings and conflicts
of interest.
CITs will not fix everything in the 403(b) market.
However, we support the proposal because
it is a common-sense, straightforward way to
help some plans get a lot better. Simply put,
workers in 403(b) plans deserve access to
the same best-in-class investments as workers
in other retirement plans, and CITs can
often provide the best value compared with the
mutual funds and annuities available in most
403(b) plans.

We also have some ideas to improve
the legislation to ensure that it confers some
important participant protections.
What Are CITs, and What's Their Benefit?
CITs are pooled investment vehicles organized
as trusts and maintained by a bank or trust

1 The bill was introduced by Rep. Jimmy Panetta, D-Calif., and co-sponsored by Reps. Ron Estes, R-Kan., Brendan Boyle, D-Pa., Darin LaHood, R-Ill., Madeleine Dean, D-Pa.; and Andy Barr, R-Ky.

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Morningstar - Q3 2020

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