Recently, Deutsche Bank published a report that highlighted how European ETF providers have been able to generate surprisingly high profit margins. The report attributes these high margins in part to relatively large returns generated in the murky world of securities lending. There’s nothing inherently wrong with the practice – in fact it can and should create wealth for investors – but certain companies are in the habit of keeping much or all of the generated profits. I’m amazed that investors and the media aren’t up in arms about this.
Securities lending refers to the practice of a fund manager (responsible for an ETF, mutual fund, or other institutional pool) loaning (to a short seller, for example) the underlying stocks or bonds in exchange for a fee. This is desirable because it is a way to generate extra income from the stocks or bonds that are just sitting around in the portfolio collecting dust. When the investment is loaned out the beneficial ownership doesn’t change hands and the fund manager can ask for the stock or bond back at anytime he or she wishes (typically when selling the position).
I’ve glossed over all sorts of intricacies for the sake of brevity, but there are two main points to keep in mind. First, when a fund manager loans out securities, there is always the risk that he or she won’t get the securities back. Second, the loaned securities belong to the fund investor, not the fund company or fund manager. Consequently, it is the investor who is on the hook for any related losses. To be fair, it’s a fairly low risk strategy, but the potential for losses does exist.
The stink of it is that numerous fund providers are keeping much or all of the profits generated from the practice. The industry argues that securities lending creates wealth for investors and that the fund manager deserves to be compensated for performing the service on investors’ behalf. Furthermore, they would argue that this fact is typically clearly disclosed in the prospectus.
But I would argue that the investor is already paying for this service via the fund’s expense ratio. If that fee isn’t enough to cover the manager’s securities lending efforts, then the fund company should simply raise the expense ratio; not keep a fat chunk of the profits that belong to the investor.
Taking a cut of the securities lending profit seems to me a thinly veiled attempt to obfuscate the fund’s true fees. By taking a cut of securities lending revenue right off the top, the fund provider can keep that cost out of the highly scrutinized expense ratio in favour of a disclaimer buried in the prospectus. There’s no question that the expense ratio is the far more logical and transparent place to charge the investor for securities lending.
The expense ratio is the fee that compensates all sorts of managers of all sorts of products (mutual funds, ETFs, hedge funds, etc.), employing all sorts of investment strategies, whether active or passive (long only, long/short, market neutral, merger arbitrage, index replication, synthetic indexing, currency hedging, and so on). But for some reason this one practice is not covered in the expense ratio. That seems exceedingly odd to me. It’s akin to a long-only fund manager keeping the profits made on the fund’s currency hedging activities. That certainly wouldn’t be deemed acceptable. So what makes securities lending so different that it should warrant such unique accounting treatment?
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