New ETF Problems You Need To Know About

There is a new batch of ETF problems surfacing that you need to know about if you invest in Exchange Traded Funds. Even though ETFs are touted because of their very low fund fees, they may not be as benign as previously thought. Investment News recently wrote about a shareholder lawsuit that has been leveled against iShares – one of the three largest providers of ETFs in the market.

What’s all the hoopla about?

In a word; securities lending. This means that ETFs and mutual funds can rent out the securities they hold in their portfolios (if their prospectus allows it). When you select your ETFs, please don’t ignore this. Here’s why.

When they lend out holdings they collect a fee from the borrower. The funds do this because they like earning the money. The down side to this practice is that it exposes investors to more risk.*

If you can handle that risk, the practice isn’t terrible per se. Keep in mind that securities lending is extremely lucrative. According to Markit Group Ltd, the average fee these companies receive is in the neighborhood of 40 basis points (.4%). So far so good.

But what isn’t so good is when the fund companies slip a little too much of what they collect into their own pockets. The law suit Investment News reported on deals with a complaint by two large investors.

They claim that iShares earned about $500 million in 2011 and part of 2012 through securities lending. And while the prospectus allows iShares to pocket 35% of those fees, the suit alleges that the firm actually snatched up 40%. That extra 5% represents $25 million dollars. I don’t know about you, but to me that’s a lot of cabbage.

But this $25 million isn’t the main point if you ask me. My question is, why should the fund company keep any of these profits? It belongs to the shareholders – not the fund. There is no question that this “wealth redistribution” by the company hurts ETF investors.

What can you do about it?

If you want to make sure that your fund company doesn’t eat your lunch, all you have to do is spend an extra 5 minutes and review the prospectus. It isn’t that complicated and most aren’t written in legalese.

Open up the prospectus and Statement of Additional Information on line. Then do a search for the term “securities lending”. I
looked at a few ETF prospectuses and when I did that search I found that all three of the largest ETF companies engage in securities lending. But each of these companies kept different amounts. Some kept none of the fees. They passed all the money to their investors. Other firms kept a great big piece of the pie.

I must admit that while it was easy to discover that the funds engage in this practice of lending out holdings, it was very difficult to identify the amount they charge for doing so. If you are unable to find the number that spells out the split, just call the company and ask.

While you are at it, check on your mutual funds as well. As I said, they too may be involved in securities lending without you knowing about it.

There is nothing wrong with investment companies making money. But there is a lot wrong with an investment firm that gets too greedy. Make sure you know if the ETFs and funds you buy lend out securities and if so, how much of the premiums are passed on to the investors and how they retain.

Are you going to check if your ETF or mutual fund lends out securities? If not, why not?

* Here’s a sample prospectus that I randomly selected from iShares. They do a good job of explaining the risk involved:

Securities Lending Risk. The Fund may engage in securities lending. Securities lending involves the risk that the Fund may lose money because the borrower of the Fund’s loaned securities fails to return the securities in a timely manner or at all. The Fund could also lose money in the event of a decline in the value of the collateral provided for loaned securities or a decline in the value of any investments made with cash collateral. These events could also trigger adverse tax consequences for the Fund.