September 2019 Retirement Times

By Higginbotham on September 24 , 2019

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Index Funds Looking Beyond Fees

Ryan Hamilton, Investment Analyst

The flow to passive management is one of the biggest talking points of the decade. With this shift came the daunting task, and responsibility, to better evaluate the abundance of index funds offered by the marketplace. Index funds seek to replicate the performance of a benchmark, making the idea of comparing returns appear counter intuitive.

This notion has led many to focus almost entirely on fees. During this time period the industry experienced significant fee compression, with the difference between a few of the most commonly utilized index funds as small as 0.002 percent. This amounts to $2 for every $100,000 invested. Relative to the administrative burden to switch funds, investment cost is not the best method of selecting funds, especially considering that shortly after, a different fund may be the new lowest-cost option.

How else can an index fund differentiate itself from its competitors – if not fees, what should be evaluated? The best index fund managers provide tight benchmark tracking at a reasonable price, and two techniques they can incorporate into their investment process are cross trading and securities lending.

Through the application of certain trading techniques, index managers can reduce cost and improve tracking. Over time, the composition of indexes change, yet the process funds undergo to match these changes are complex. For example, as companies grow, they may move from the small cap index into the large cap index. For the index, this is a simple process. One day the company is in the small cap index, and the next day they are in the large cap index. No trading needs to occur, no commissions paid, no bid-ask spreads crossed, no trades routed – yet funds must overcome these hurdles if they want to match the index’s performance.

One technique to overcome these challenges is through the use of cross trading. Suppose a fund company offers a small cap index fund and a large cap index fund, and “company X” is being moved from the small cap index to the large cap index. The fund company could sell all its shares of “company X” in the small cap fund. This incurs cost and drives the price down as they sell. Then it buys all the shares back in its large cap fund, driving the price up as it buys. Through cross trading, this process is more streamlined. The fund company transfers its shares of “company X” from its small cap fund to its large cap fund without incurring costs. This leads to reduced tracking error and improved performance. To conduct due diligence on an index manager’s cross trading capabilities, examine the index fund company’s cross trading process and review percentages of trades crossed.

The second method by which an index fund can be evaluated is through its use of securities lending. Securities lending refers to the temporary lending of a stock, derivative or bond by one party to another in exchange for collateral. The collateral can be reinvested to produce income for the lender. Securities lending is important to short sellers who profit when securities drop in value. If an active investor is looking to short “stock ABC” currently worth $100, it can borrow “stock ABC” from an index fund, offering the fund $103 as collateral. The index fund can invest this cash until the stock is returned, generating extra return, helping offset the costs the fund faces.

It is important to remember this is not risk-free money for the fund. This process exposes the fund to counterparty risk – which is when the active investor does not return the stock owed. The second is reinvestment risk – when the fund invests the $103 and it loses value. To mitigate this risk, many fund companies have adopted SEC or OCC money market guidelines that outline the maturity, credit ratings and liquidity restrictions on the collateral investment. Well established index providers will furnish information on their counterparty and collateral guidelines.

How much extra return can securities lending generate? Looking at the graphs below, we can see significant additional return through securities lending, sometimes in excess of the management fee charged by the fund.

500 Index Fund
Fund Company % on Loan Revenue Split (fund/lending agent) Yield to Fund
BlackRock CIT 6.1% 50/50 0.016%
Fidelity 0.9% 90/10 0.002%
State Street CIT 1.8% 70/30 0.004%
Vanguard 0.13% 95/5 0.001%
Small Cap Index Fund
Fund Company % on Loan Revenue Split (fund/lending agent) Yield to Fund
BlackRock CIT 29.2% 50/50 0.15%
Fidelity 18.9% 90/10 0.20%
State Street CIT 18.8% 70/30 0.15%
Vanguard 1.96% 95/5 0.10%


International Index Fund
Fund Company % on Loan Revenue Split (fund/lending agent) Yield to Fund
BlackRock CIT 2.4% 50/50 0.023%
Fidelity 1.3% 90/10 0.015%
State Street CIT 1.2% 70/30 0.021%
Vanguard 1.32% 95/5 0.067%


Bond Index Fund
Fund Company % on Loan Revenue Split (fund/lending agent) Yield to Fund
BlackRock CIT 37.8% 50/50 0.063%
Fidelity <0.1% 100/0 0.001%
State Street CIT 10% 70/30 0.029%
Vanguard 0% N/A N/A

Source: 2018 Securities lending information

These complex features, prevalent amongst passive managers, explain why RPAG tailored the scorecard to evaluate passive managers on analytics and metrics specific to, and important for, passive funds. On the surface, it might seem counter intuitive to include an analytic on return rank for a passive fund designed to match the performance of a benchmark. However, by including return rank, we evaluate a fund’s effectiveness in securities lending and cost reduction through cross trading.

Two analytics dedicated to tracking error may seem unnecessary, however, performance matching is a primary objective of passive funds. It is critical for managers to utilize every tool in their toolbox. An emphasis on tracking error allows for better assessment of how well managers are meeting this objective. While fees are an important component of evaluating a passive manager, it is not the only data point, and the RPAG scorecard incorporates all significant components into the analysis.

For more information about cross trading and securities lending, reach out to your plan advisor.

About the Author
Ryan is an investment analyst for RPAG. He works closely with advisors and plan sponsors on manager due diligence and conducting market and fund research. Ryan is also a member of the RPAG Investment Committee, where all quantitative and qualitative aspects of the investment due diligence process are vetted and discussed when providing manager recommendations at the firm level for the firm’s entire client base. Ryan specializes in fixed income, cash vehicles, and alternative investments. Ryan graduated magna cum laude with a Bachelor of Arts from UCLA, and is a CFA Level III Candidate.

Student Loan Contribution Programs: The New Way to Recruit and Retain Millennials in Today's Workplace

As human resource managers begin working on updating their benefits package, it’s important to remember that millennials are quitting their jobs faster than employers can hire them1 – which is especially problematic considering millennials now make up 50 percent of the workforce2.

The reasons for resignations vary widely, but one retention solution may be to consider offering a student loan contribution program. In 1999, the amount of outstanding student loan debt was approximately $90 billion. In 2019, that amount that has grown to nearly $1.6 trillion – held mainly by millennials. It’s fair to say that this population is desperately looking for some relief from this heavy debt burden – which offers a unique opportunity for employers to recruit and retain millennial talent.

A recent survey by Laurel Road found that millennials who were offered a student loan contribution program in their benefits package stayed at companies five years longer than those who were not. Some surveys even concluded that a student loan contribution program can be more desirable than vacation days3.

A byproduct of the student debt problem is that millennials may not be saving enough for retirement. A recent study from Boston College’s Center for Retirement Research found that college graduates with student debt accumulate 50 percent less retirement wealth in their retirement plan by age 30 than those without4.

Many employees believe they must choose between paying off their loans and saving for retirement, however, a student loan repayment program allows employees to make considerable contributions to both their debt and retirement savings accounts.

Student loan contribution programs are offered at little to no cost by different providers, are fully tailored to most benefit programs and most importantly, may offer a solution to the student loan debt crisis. A majority of these innovative plans are set up in three unique ways:

  1. Refinancing resources, which offer financial wellness tools as well as access to third-party loan refinancing.

  2. Loan contribution programs offer employer monthly contributions to employee student loans in addition to refinancing resources.

  3. Match contributions, where employers make a retirement plan match when employees make a tuition loan payment. Again, refinancing resources are included.

These programs vary in shape and size, allowing companies to integrate this benefit with little interruption to company operations. The more competitive programs will offer refinancing, allowing workers to make smaller payments at less of an interest rate, with little to no cost to the employer. At its core, this program increases employee retention by reducing the financial strain brought on by student loans.

Consider implementing a student loan contribution program into your benefits strategy. You may find that your ability to recruit and retain millennial talent increases immensely!


Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS) an affiliate of Kestra IS. Kestra IS and Kestra AS are not affiliated with Higginbotham.

The “Retirement Times” is published monthly by Retirement Plan Advisory Group’s marketing team. This material is intended for informational purposes only and should not be construed as legal advice and is not intended to replace the advice of a qualified attorney, tax adviser, investment professional or insurance agent. (c) 2018. Retirement Plan Advisory Group.

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