If you have financial assets invested using the popular “passive” investment strategy, your investment manager may be earning more from your investments than you know.
Buying and holding securities in passive investments such as exchange traded funds (ETFs) and index mutual funds (IMFs) saves investors significantly on transaction costs and management fees. Less known to investors, ETFs and IMFs are ideal instruments for securities lending because they use buy-and-hold strategies and aren’t usually abruptly sold.
“With passive investing, investors only care about matching the index return, not whether the index goes up or down,” said Jesse A. Blocher, assistant professor of finance at Vanderbilt University’s Owen Graduate School of Management. “Consequently, investment managers’ decision to lend the stocks in their portfolio is a ‘no-brainer’.”
A study by Blocher and Robert E. Whaley, Valere Blair Potter Professor of Finance at the Owen School, found that many fund providers earn significant revenue through securities lending by ETFs and other passive investments.
In a typical lending agreement, a borrower posts 102 percent of the notional value of the stocks in cash with the lender as collateral. The lender then invests the cash collateral in money market securities and earns a market-determined risk-free rate of return. Since the interest income properly belongs to the borrower (the owner of the cash), the lender passes the interest income to the borrower, but only after extracting a lending fee. The original investor may see little or none of this profit.
Whaley and Blocher say they take no position on whether the practice is fair to passive investors.
“Instead, we argue for greater transparency around which securities are lent, fees generated from this behavior, and how much is retained by the lending agent versus passed on to the fund management company, and ultimately, the investor,” Whaley said.
“Current practices are unacceptable. Investors are not allowed the opportunity to truly understand their investments and fees, thereby undermining comparisons across investments.”
Read the full article, “Passive Investing: The Role of Securities Lending” on SSRN.COM.