Two Deutsche Bank strategists recently penned a report that said that exchange-traded fund issuers can easily earn twice their funds’ management fees through other, ancillary activities.
Christos Costandinides and Daniel Arnold argued that synthetic ETFs earn extra money primarily from trading (including from the provision of derivatives), while the issuers of physical ETFs gain from lending out the shares and bonds owned by the investors in their funds.
The authors didn’t go into detail. Generally speaking, though, the sources of extra revenue are hardly a secret.
It’s been well publicised that synthetic ETF providers have an economic incentive to put lower-quality assets or collateral into their funds. If they had to set aside the actual shares or bonds in the index being tracked by their ETFs, rather than what they put into these funds in practice, they’d have to pay more to do so.
“The concept of stuffing ETFs with any old clag collateral is a tried and tested revenue scheme,” one retired banker and former derivatives specialist put it bluntly.
In funds that use physical replication, securities lending revenues, of which issuers often take a healthy cut, can be substantial.
Many commentators, IndexUniverse included, pointed out that BlackRock was willing to pay more than double for Barclays Global Investors in 2009, securities lending and other operations thrown in, than what another party initially offered for iShares, the firm’s ETF management unit, alone. The differences in the values of the respective potential revenue streams were made clear.
In the Deutsche Bank report, Costandinides and Arnold argued that an increased level of transparency by issuers would address many of the potential concerns of investors and help the ETF industry to continue to grow. It’s hard to argue with that.
But there’s still a long way to go. We’re far from uniform disclosure of synthetic ETFs’ assets/collateral. Only three European issuers out of more than a dozen that use this fund structure give a daily snapshot of what their funds really hold.
And when it comes to securities lending, things are arguably even more opaque.
In a letter sent in May by Karrie McMillan, the general counsel of the US Investment Company Institute (ICI, a trade body for US fund managers), to the secretariat of the Financial Stability Board, in response to the FSB’s April note on ETFs, there’s an interesting section, right at the end, devoted to the subject of share lending.
The ICI’s main argument, as expressed in McMillan’s letter, is that the large majority of ETFs worldwide do not share the characteristics of the (European) synthetic ETF structure, and that global regulators should therefore exercise caution in making broad statements about potential ETF-related risk.
When it comes to securities lending (also highlighted by the FSB as a concern, given possible conflicts of interest) McMillan said that the Investment Company Act of 1940 (the law regulating most US ETFs) “generally prohibits a fund from lending its securities to an affiliated person or using an affiliate as a securities lending agent. The SEC has granted individual exemptions to this prohibition, subject to a number of conditions designed to ensure that the affiliated person does not take advantage of its relationship with the fund”.
“It is important to note,” McMillan continued, “that all profits from securities lending (i.e., revenues less fees paid to a lending agent or other involved parties, as approved by the fund board) accrue to the fund itself, not the adviser. While an adviser may receive fees if it is acting as the lending agent, those fees must be fair and reasonable, as determined by the fund’s board of directors.”
This sounds reassuring. But if you dig a little deeper you’ll find that different exchange-traded fund boards vary widely in their definitions of what “fair and reasonable” means, while the same fund company might even apply different rules in different jurisdictions.
BlackRock, for example (as one of the “affiliated” lending agents that has obtained an SEC exemption) keeps 40 percent of its ETFs’ lending revenues, down from a 50 percent cut that applied prior to November 2010.
But according to an article published last year in Portfolio.com, State Street, the world’s second largest ETF issuer, only retains 15 percent of its US ETFs’ lending revenues, while Vanguard apparently returns nearly all securities lending revenues, after costs, to investors.
And while State Street takes a 15 percent cut of its ETFs’ revenues from lending stocks in the US, the firm charges its ETF investors over three times more in Europe for doing the same thing—50 percent. Why the difference?
Unfortunately, having a majority of independent fund board directors doesn’t guarantee that things can’t go wrong. The legal provisions in the US fund rules that enshrine this requirement didn’t prevent the mutual fund timing scandal of 2003, one commentator on fund governance has pointed out.
Meanwhile, in Europe there’s a very wide variety of fund structures, with no regulatory requirement at all to have independents at board level, said Douglas Ferrans, our interviewee last week and chairman of the UK’s equivalent to the ICI, the Investment Management Association. There are clear governance weaknesses in some European fund jurisdictions, the IMA believes.
Given the scale of earnings that can be made over and above ETF management fees, it’s clear that there are plenty of reasons for fund boards to be looking closely at issuers’ practices when it comes to share lending, charges for derivatives and the security and quality of collateral provisions.
And some standardisation of exchange-traded fund practices in these “ancillary” fee-earning areas seems long overdue. If the ETF industry can’t come up with its own rules, it looks increasingly likely that regulators will impose some.