I have been thinking for a while about posting on “securities lending,” the practice where mutual funds and exchange-traded funds (ETFs) lend out securities in their portfolios to mainly hedge funds for short selling. But Jason Zweig’s May 30 column in the Wall Street Journal beat me to it and expresses many of the concerns that I was mulling over.
One was how the lending fees are split between fund investors and fund managers. It appears many funds do not fully, or even partly, rebate the income to fund holders in the form of lower fees or higher returns — even though the securities are being held in trust for fund holders.
Zweig said T. Rowe Price Group and Vanguard Group fully rebate lending fees (after expenses) to fund holders. He named some smaller funds that don’t. The elephant in the room he did not mention in this regard is Barclays and its iShares family of ETFs (presently on the auction block).
They take 50% of the security-lending revenues, which are becoming quite large these days. Barclays’ accounts indicate that the British bank earned £389 million from the practice last year on all its funds under management (of which iShares represents about one-fifth).
Barclays gets a 50% cut because it’s specified in the contract that the board of directors at iShares gave them to manage the lending operations on behalf of unit holders. Couldn’t the board have found managers that would be willing to perform the lending function at a fraction of the fees charged by Barclays?
Indeed, this makes one wonder if the iShares board really is functioning in the interests of fund holders. If the lending function were transferred to an arm’s length party, wouldn’t it be possible to allot more of the lending fees to substantially lowering management expense ratios?
Actually, at present growth rates in securities lending, it’s not inconceivable that ETFs could some day be offered to investors without any management fees – and/or with better performance than the indexes they track. Image that: buying the iShares S&P 500 Index Fund (IVV) with a 0% MER and earning a net return that is a percentage or two greater than the S&P 500. What a concept.
I’ll have more to say on this topic in a column scheduled to appear this Thursday after 4PM (EST) on the home page of Canadian Business (and later, in the column archives). Other issues pertain to the use of the borrowed securities for short selling and the risks in lending securities.