CHICAGO – Fees on index mutual funds and exchange-traded funds attract the eyes of investors and analysts, but Morningstar is shining some light on other aspects that affect fund performance but don’t often catch much attention.
For example, securities lending seems to be a natural for funds full of shares being held for the long haul, but not all asset managers take full advantage of lending. They also handle the proceeds differently, some directing it into the fund to boost performance (and effectively cutting their fee to zero) and others keep some of the revenue to supplement barely-there management fees.
Those were a couple of findings that Alex Bryan, Morningstar Director of Passive Strategies Research, North America, plans to highlight with two other analysts during the session, “ETF and Passive Investments Research Highlights” during this morning’s start of the Morningstar Investment Conference.
As companies cut management fees to near zero, they have fewer distinguishing selling points because they are offering the same index. So, managers are looking to boost performance with practices such as securities lending – and Morningstar wants to see how those companies are pulling those levers.
“It’s harder to keep tabs on it,” Bryan said of securities lending. “But in a world where asset managers are fighting over a few basis points and investors are increasingly treating index funds as commodities, it’s something that is worth paying attention to. It’s worth asking asset managers, ‘Why you taking X% of this revenue when the risks are really on the investors in the fund?’ It’s important for investors to look at this as part of the whole cost that they’re paying into the asset manager.”
That slice paid to the asset manager for an investor’s risk in lending the security is tiny. The amount going back to the manager, if anything, is usually a small portion of the revenue.
“For the most part, most of that income goes back to the fund and the asset manager doesn’t really keep most of that money,” Bryan said. “They may keep some of it in some cases. The practices vary by provider. A lot of times the agent who actually facilitate this arrangement takes the cut before giving that [security] back to the fund company.”
Some managers are cutting out that middle broker – or inserting themselves, as a way of producing revenue as they cut management fees.
Fidelity reached the bottom in the fee race, offering zero-fee mutual funds last year. Securities-lending is one way for the company to generate revenue and acting as the lending agent is another boost.
“They had previously been using I believe it was Goldman Sachs as their lending agent to facilitate these types of transactions” Bryan said. “They’re going to be doing that themselves going forward, at least for U.S. stocks. That’s a way that Fidelity, the asset manager, as well as the lending agent, can earn some revenue off of these funds through that securities lending as a way of kind of recouping some of their expenses associated with operating the funds.”
The risk to investors in lending securities is slight – because of the substantial collateral the borrower has to provide, usually exceeding the value of the borrowed security itself.
The investor is usually the winner when the manager lends securities. In fact, the income can reduce the fund’s expense ratio effectively to nearly zero.
In an example from a Morningstar report: “The average securities-lending income yield for iShares Russell 2000 ETF IWM was 0.19% from March 2007 through March 2018. This almost completely offset the fund’s expense ratio, which held steady at 0.20% during this span. Investors that held IWM over this time frame effectively paid 0.01% annually to track the Russell 2000 Index.”
Also from that report, “Securities Lending: An Examination of the Risks and Rewards,” here is how funds used the income:
“One of my favorite exhibits is a chart that shows offsets by securities lending, by year by asset manager,” Bryan said. “There are two components that go into that. The fee that the asset manager charges as well as the income they generate through securities lending. So, a company like TIAA has actually been able to offset a decent chunk of their fees through securities lending. But you’ll see here that in a lot of cases the fee is not telling you the whole story because the asset manager can recoup some of that through securities lending.”
The use of securities lending also reflects the manager’s overall approach. Vanguard, for instance, tends to lend only if it earns attractive compensation.
“Vanguard, the reason that they don’t lend as much is because they’re very conservative,” Bryan said. “BlackRock is able to generate more income and aggregate from that because they have more securities on loan, but they’re lending out oftentimes securities that offer lower yields than what Vanguard’s willing to lend out.”
Small caps tend to command a better yield because of the smaller supply of shares to lend, compared to the mid and large caps.
Although securities-lending is a small revenue factor in asset management, it merits watching, Bryan said. It also merits caution in depending on the practice.
“It’s important to understand what that split looks like and, to be mindful of the fact that even though this can help performance, it’s a less reliable performance enhancer than cutting fees,” Bryan said. “So if I’m able to earn 10 basis points this year, it doesn’t necessarily mean I’m going to be able to earn 10 basis points next year. Securities lending revenue is volatile and it does change over time, but it’s one way in which the asset manager can recoup some of the costs.”
Steven A. Morelli is editor-in-chief for AdvisorNews. He has more than 25 years of experience as a reporter and editor for newspapers and magazines. He was also vice president of communications for an insurance agents’ association. Steve can be reached at firstname.lastname@example.org.
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