Trust Advisor Survey: Surge in ERISA lawsuits, 2008 Advisor Performance Prompts Trustees to Turn Down New CTF Business; Regardless of Risk Compelling Benefits Remain

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Common trust funds aren’t so common anymore. Wall Street’s on‐again off‐again love affair with common fund pooling arrangements appears to be on the rocks (at least for the time being), according to research conducted by The Trust Advisor Blog since the beginning of the year.

Chicago‐based Northern Trust, known to be a CTF platform provider of third‐party hosting arrangements for RIAs, reported “they no longer offer their platform for managers,” said Anna Jamroz of Northern Trust’s Global Fund Services group. Several other major banks have also ended the practice of permitting third‐party investment advisors to direct the portfolios held in common trust fund accounts.

These arrangements permit the CTF’s to re‐create mutual fund portfolios. Typically, this helps investors by lowering operating costs. Common fund accounts don’t require the expensive operating costs of a mutual fund such as printing, compliance, call centers, etc. All of this translates into lower expense ratios which benefit investors. Both Morningstar and Lipper maintain databases of over 1,000 funds for the purpose of tracking performance. Most of these CTF’s are hosted by banks or trust companies that also serve as investment advisor to the fund.

The history of common trust funds, or CTF’s, dates back to the Jules Verne era and they are almost as old as Wall Street itself. In simple terms, these arrangements permit the comingling or pooling of investors’ money into one account (known as a common fund) for the purpose of creating a single investment.

In other words, they are much like a mutual fund. However, CTF’s are not required to be registered with the Securities and Exchange Commission and they are not considered to be a security under state and federal securities laws. They are regulated under OCC Regulation 9 (12 CFR 9.18) and are supervised by state or federal bank regulators.

Just 16 months ago, collective funds were the darlings of Wall Street. They were featured in a July 24 article in The Wall Street Journal, “‘Collective Funds’ Gain Traction in 401(k)”. The WSJ reported “collective funds pool investors’ assets and invest in stocks, bonds and other securities. The chief difference: Collective funds are typically available only in retirement plans. Because they aren’t sold directly to the general public, they generally aren’t regulated by the Securities and Exchange Commission.”  The story added, “Collective funds tend to be substantially cheaper than mutual funds, largely because they don’t have to comply with SEC regulations or market to retail customers. That’s driving 401(k) plans to embrace these products, which are offered by big fund providers like Fidelity Investments, Vanguard Group and Charles Schwab Corp.”

Risky Third Party Arrangements

In a typical CTF setup, there is a trust and a trustee. The investors are called participants which are similar to shareholders. But because of the very nature of the arrangement as a trust, the trustee maintains full fiduciary responsibility. This includes responsibility for the profit or loss of the fund. The trustee cannot unload, delegate or bifurcate investment responsibility to a third party investment advisor without liability. In other words, the trustee is liable and responsible for the investment decisions of the advisor. If the common trust fund loses money, the trustee may be on the hook to make the investor whole in the event of a claim against the fund for a recovery.

All of this makes trustees very nervous when it comes to serving as trustee of a CTF managed by an investment advisor whose track record may have sustained losses. Since most advisors sustained double‐digit losses last year, it’s easy to see why trustees are scared.

In recent years, trustees have prided themselves on opting into roles that expressly limit their liability. These include directed trusts which permit the trustee to bear no responsibility for investment decisions as long as a directed trust is properly constructed and administered.

The Next Bull Market Scenario

A serious market recovery, renewed investor confidence and a boost in retirement wealth may spark another round of CTF mania in the coming years. If it does, there are mutual benefits for both the investor and the provider.

For the investor: he gains the ability to participate in fractional shares of managed accounts normally reserved for ultra‐high net worth investors who are prepared to put in $3 million to $4 million. With a common trust fund, an investor with as little as $100,000 or $200,000 can buy a share of a managed account and participate in the strategy and the gains (or losses) of a best‐of‐breed advisor.

Models that Work Now

According to reports filed with the Securities and Exchange Commission, Westwood Trust‐owner Westwood Holdings Group (WHG) of Dallas, TX hosts multiple common trust fund accounts. In this case, Westwood is also an investment advisor and also owns a trust company. This all‐in‐one arrangement does not put the responsibility of third‐party risk on its shoulders since the parent/owner is familiar with the strategy of the advisor and owns the trust company.

In a situation where the investment advisor owns a bank or trust company, CTF’s can make a lot of sense. Since there is no outsourcing of risk, the advisor feels comfortable about its strategy and therefore is willing to accept the additional responsibility associated with maintaining the CTF account.

In another scenario, Davidson Trust of Montana is a combined trust company and investment advisory firm which offers its customer CTF accounts of pre‐approved and selected portfolios. I spoke to Davidson Trust Vice President Dennis West, who told me that their CTF accounts are popular with their investors. The firm has six different portfolios to choose from. Although the loads are somewhat heavy for smaller accounts of $1 million or less, the fees become lower when you leave Davidson more funds to work with. For more information, you can reach Dennis West at 1‐888‐389‐8001.

As more investment advisory firms begin to integrate trust operations, it makes more sense to also host common trust funds for these purposes. Given the compelling benefits these arrangements can yield investor savings and an ability to get into a fund with a best‐of‐breed strategy for a lower entry charge.

Jerry Cooper, senior editor, The Trust Advisor Blog. Steven Maimes contributed to the research.