What’s Aldous referring to?

The iShares website states that “Costs are a key consideration when selecting an ETF…However, an ETF's TER forms just one element of its total costs. Investors should also consider the impact of additional implicit costs such as trading costs and portfolio rebalancing. On the other hand, ETF portfolio managers can also take a number of actions that provide additional revenue which can be used to offset these costs, such as securities lending. Any proper evaluation of the different ETF options should also consider the likely impact of these extra revenue sources.”

It’s hard to argue with this – but should iShares go one step further and adjust TERs to reflect these securities lending revenues?

I think not, for a few reasons.

For a start, the TER is meant to reflect the unavoidable operational costs involved with running the ETF – it covers the fund management fee, trustee, licensing, custodial and adminstration costs. Furthermore, the TER is typically capped by the issuer at a given percentage level, ensuring a predictable outcome for investors.

Securities lending revenues are variable – they differ from fund to fund and depend on the opportunities available to the fund manager at the time in the given asset class – but more importantly, they are the result of an investment decision and incur associated risks.

As the iShares prospectus makes clear, “The company will have a credit risk on a counterparty to any securities lending contract. Fund investments can be lent to counterparties over a period of time. A default by the counterparty combined with a fall in the value of the collateral below that of the value of the securities lent may result in a reduction in the value of a fund.”

No return without risk, in other words.

Next, if you’re going to adjust the TER for lending revenues, why not also do so for the other implicit costs iShares refers to – trading and portfolio rebalancing costs? These are real costs of investment too.

No doubt it would be possible to derive some number to reflect all these “investment” costs, but there is surely a risk that doing so would detract from, rather than add to, the transparency of ETFs. Plus, there would be increased opportunities to game the numbers in a way that investors would find very hard to track.

Finally, as I described in a blog last week, there are potential collateral costs in swap-based ETFs (and ETCs) that may not be reflected in the expense ratio. But I’m not sure that the answer is to change the TER.

What is surely needed is more transparency regarding all the non-operational costs of ETF investing – whether they relate to securities lending, index licensing fees, the collateral costs in swap-based ETFs, index turnover or trading (I haven’t even touched on the compexities of executing ETF orders in Europe, given multiple listings, trading venues, order methods and technologies).

Christopher Aldous has highlighted an important issue relating to indexed investing – what you see isn’t always what you get. But in my opinion those in the tracker fund industry need to tread carefully on this subject to avoid creating even more confusion amongst end-clients.

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