New guidelines may force exchange traded funds (ETFs) which lend their assets to return any revenues they make to investors, rather than allowing the fund provider to profit. However, some fear that this may cause ETF fees to rise.
At the end of July, the European Securities and Markets Authority (ESMA), an independent European Union authority that helps to safeguard the stability of the EU's financial system, published guidelines aimed at strengthening investor protection in respect of funds that fall under the Ucits (Undertakings for Collective Investment in Transferable Securities) regime. The guidelines in particular focused on exchange traded securities (ETFs) and one provision came as a particular surprise. ESMA recommended that ETFs which engage in stock lending must return all revenue they make from this, net of costs, back to fund shareholders, rather than allowing fund providers to keep some of the profit.
Stock lending is when a fund temporarily loans the securities it holds to a third party in exchange for a fee. Securities are normally lent on an open basis with no fixed maturity date, which gives lenders the flexibility to recall their securities at any time. Physically replicated ETFs, which buy the shares they track, can benefit from the revenue they make by stock lending, for example, partially or completely offsetting management fees and other sources of tracking error. This is useful for physical replication ETFs because they typically have higher costs due to the fact they have to buy several shares or assets. If the extra income gets incorporated into the fund's net asset value (NAV) it can mean the ETF tracks its index more closely or sometimes outperforms it.
ETFs can also cut tax bills by securities lending, especially during dividend season. ETF providers lend stocks that are subject to dividend withholding tax to counterparties located in more tax efficient jurisdictions. In this way, physical replication ETFs can avoid a portion of the withholding taxes levied on dividends by European countries.
However, if ETFs have to return all the revenue they make from stock lending to investors some fear that ETF providers may raise fees or the ETF will not track the return of their index so closely.
"These revenues did not correspond to disproportionate profits but allowed ETFs to show lower management fees," comment analysts at EDHEC-Risk Institute. "As a result of receiving all of the lending profits, the ETF can now expect its management fees to increase."
Others suggest that ETF providers may just stop stock lending if they cannot profit from it.
No change?
Physical ETF providers may refrain from raising their fees substantially because they will still want their products to compete with synthetic ETF providers who already often have lower charges, and open-ended tracker funds.
Another reason why charges may not change that much is because ESMA's recommendations are not set in stone: local regulators in each European country will implement them according to their interpretation. In the UK this will be the Financial Services Authority (FSA). Local regulators have a few months to interpret them and implement them, and then providers will have around a year to put them in place.
Even if the FSA recommends the guidelines in full, in practice providers may still not have to return the full profit made from securities lending. ESMA recommends that "all the revenues arising from efficient portfolio management techniques, net of direct and indirect costs and fees should be returned to the Ucits (fund)."
What the costs are and what they amount to, leaves room for interpretation, according to Gordon Rose, ETF analyst at fund information company Morningstar. "With the new ESMA guidelines, we believe there is no guarantee that more money will be returned to fund shareholders," he says. "Providers who consider they are charging reasonable costs for their services may not pass on more income to the fund. They may only change the way they disclose their arrangements going forward, stating that 100 per cent of lending revenue is returned to the ETF, minus the fees paid to the fund manager and or the lending agent, which may effectively be equivalent to the share of gross revenue they are retaining today."
At present, a fund provider might claim to split securities lending revenue 50/50 with the fund investor. In compliance with the new guidelines, the same provider could keep the same amount for itself and claim to distribute 100 per cent of the profits to fund investors, net of its own fee, which it would have to disclose in the prospectus. ESMA's proposals say that fund providers will have to disclose any direct or indirect fees and costs from securities lending, and the identity of the parties to which such fees and expenses are paid.
Risk and reward
While stock lending can help the fund it also incurs risks, hence the argument for compensating ETF shareholders for taking on risk by returning more revenue to the fund. The main risk is that the borrower of the ETF's assets becomes insolvent and is unable to return the loaned securities. However, to mitigate this risk borrowers are required to post collateral for the duration of the loan in order to secure their obligation to return the borrowed securities. This collateral typically takes the form of securities or cash, and is equal to at least 100 per cent of the value of the lent securities to account for the risk of subsequent fluctuations in the value of the assets on either side of the loan. Collateral is normally held in a segregated custodial account in the name of the fund.
There is a chance that if a borrower defaults that the collateral won't be sufficient to repurchase the lent securities, if for example, the value of the original assets has risen significantly and the counter party becomes insolvent before they can make up the difference. If this occurs, ETF shareholders would suffer a loss equal to the difference between the value of the collateral and the replacement cost of the lent securities. This risk can be mitigated by taking high quality, highly liquid securities and applying appropriate margins/haircuts to ensure maximum liquidation value for ETF shareholders.
While concerns about securities lending have been raised around physical ETFs, many types of funds engage in lending, so if you hold a unit trust or investment trust, for example, they may also be lending their securities. Morningstar says that mutual funds, pension funds and insurance companies tend to be the biggest lenders of assets. European investors made around €1bn from securities lending in 2011, and only about €40m of this is attributable to physical ETFs.
Some ETF providers are already more open and transparent about whether they stock lend, and what collateral they hold in place of the lent shares. iShares, Credit Suisse, UBS and State Street post details of their securities lending on their websites.
This is generally not the case with providers of unit trusts and investment trusts. Wealth manager SCM Private conducted a study which found that the practice of stock lending is rife among active fund managers. Read more on this
However under the ESMA proposals all Ucits funds, which include most UK domiciled unit trusts and Oeics will have to comply with the guidelines . Investment trusts, however, will not fall under the new regime as they are not Ucits funds.
