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Is the push toward zero-fee funds a race to the bottom?

The Globe and Mail by Lisa Kramer 27 August 2018

Can you imagine a world in which mutual-fund managers pay investors an annual fee – rather than the other way around? That may not be as far-fetched as it sounds.

Zero-fee index mutual funds have recently emerged in the United States, and similar management-fee-free products may soon arrive here. And there is nothing special about zero as a lower bound on fees, so don’t be surprised if negative-fee funds are next to arrive. Yes, negative fees – funds that pay investors for the pleasure of managing their funds.

But zero-fee or negative-fee funds may not be all they are cracked up to be.

The secret sauce behind zero-fee funds lies in fund managers’ ability to tap into replacement sources of revenue that can be opaque to investors. One such source is the practice of lending stock certificates to short-sellers.

Let’s suppose a day trader thinks the price of IBM will go down today. She can place a bet on her hunch by selling IBM shares short – that is, by selling the shares without owning them in the first place, in hopes of later buying them at a much lower price to close out the position at an overall profit. The act of short-selling requires that she first borrow IBM share certificates from an owner willing to lend them until she closes her short position with an offsetting purchase.

Of course, short-sellers have to pay shareholders to convince them to lend their certificates. Even with that lending fee on offer, you as an investor may not care to facilitate the speculator’s effort to profit from a downturn in IBM’s price – pressure from short-sellers can itself help push the share price lower. But your fund manager may not have your best interests at heart when they lend the share certificates underlying your stake in a mutual fund or exhange-traded fund. When they do lend shares, they return only a fraction of the proceeds to the fund unit holders, a practice that is both legal and commonplace. In the case of BlackRock Asset Management Canada, for instance, unit holders currently receive 60 per cent of the proceeds from any securities lending that takes place in its ETFs.

What happens to the rest of the proceeds? That depends. The proceeds may remain within the fund-management company as proprietary revenue or they may go to an affiliated firm that acts as an intermediary between the fund manager and the short-seller (and that intermediary may do other business with the fund manager as well, raising questions about potential conflicts of interest).

Certainly fund managers ought to be encouraged to find creative ways to increase returns for their investors, and securities lending can represent such an opportunity. But in an environment where management fees are trending lower and lower, there ought to be clear disclosure about the ways in which fund managers are offsetting reduced fees with practices that may not be in the best interest of investors.

And this brings us to the matter of risks. The aspiration to offer zero or negative fees could cause managers to change the risk profile of the fund’s holdings. In an actively managed fund, for instance, managers could tilt the portfolio holdings toward shares that happen to have a relatively high demand for shorting, resulting in high lending fees.

An investor who holds standard index funds would be relatively immune from this concern about risk because index-fund managers have very little scope to tilt holdings away from the constituents of their benchmark. In contrast, active-fund managers have much more discretion to tilt toward riskier holdings in pursuit of richer revenues from their securities-lending practices.

Such managers could even legally obscure such activities through a practice known as window dressing, where they may hold particularly risky securities except at the infrequent points in time when they must publicly report holdings, which typically occurs once every three or six months.

As the race toward zero fees and perhaps negative fees intensifies, and I expect it will, the discerning investor will stay on the lookout for managers aiming to maintain their previous levels of compensation, but in less transparent ways.

What would I like to see? Investors receiving 100 per cent of the proceeds from securities lending and other sources of replacement revenue or, in lieu of that, clear disclosure about the destination of any payments that end up going elsewhere. This may throw cold water on the prospect of zero-fee funds, but fund managers won’t do their job for free, and I like to know where my money is going.

Lisa Kramer is a professor of finance at the University of Toronto.