The ETF industry received a shake-up on July 25th, when the European Securities and Markets Authority (ESMA) published its latest set of guidelines for the European ETF market. The new policies are meant to bring more transparency to the industry and benefit investors. While some believe the rules will result in funds paying out more money to investors, this is not necessarily the case.
According to policies set forth in the consultation paper, fund managers must now return all revenue, net of costs, generated via securities lending back to fund shareholders. Fund providers will also have to disclose, in a fund’s prospectus, any direct or indirect fees and costs from securities lending, and the identity of the parties to which such fees and expenses are paid.
(Securities lending is a relatively unknown, but important, practice in the fund industry. Securities lending refers to when an investor loans out securities they own to other investors in exchange for a fee. This fee is designed to compensate the original investor for the counterparty risk associated with the borrower potentially defaulting on the loan.)
From a transparency standpoint, the new policies are great for investors, who have thus far been mostly in the dark about exactly how securities lending proceeds get divvied up. But the letter of the guidelines does not necessarily ensure that the end investor will get any more of the revenue, or that securities lending will be any less profitable for the fund providers or lending agents. Nor does it force providers to change their philosophies towards who deserves how much of the pie.
Mandating the return of 100% of revenues from securities lending sounds great, but when it’s 100% net of direct and indirect fees and expenses, and providers can allocate those fees and expenses as they see fit, the stipulation loses some of its teeth.
It’s similar to the flawed semantic logic at play in the movie business that led screenwriter David Mamet to allegedly declare that in Hollywood, “there is no net.” Various contributors to a project are pledged a percentage of its net earnings, but studio accountants allocate expenditures and fees in such a way that, technically, even the most popular films seem to break even.
Of course, the spirit of the new policies as they pertain to the actual revenue split is positive for investors, so it’s entirely possible that some fund providers will adhere to that spirit and take steps to ensure that fund unit holders get more of the benefit from securities lending. But this is not a foregone conclusion.
In securities lending, costs can be incurred at various stages of the process before the fund investor gets access to every last bit... of whatever is left. These costs can range from rebates to securities borrowers in order to facilitate relationships, to lending agent and custodial fees, to fees drawn from investments made with cash collateral, to fees taken by the fund provider for arranging the service. 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% of the profits to fund investors, net of its own fee, which it would have to disclose in the prospectus.
The ESMA consultation paper highlights an important issue, one that we’ve often argued for ourselves, that investors take the risk in securities lending and should therefore reap the bulk of the reward. The big win here is increased transparency. If these policies are enacted we will finally know what fees and costs are being incurred when the securities that investors own are lent out. In fact the guidelines apply to all UCITS funds, not just ETFs, so the improvement will be all the more pronounced for traditional mutual funds, whose investors have generally had to cope with even less information.
One hope is that that transparency will drive down those fees and costs by shedding some light on them and allowing competitive pricing pressure come to bear. Another is that fund providers will take the spirit of the policy to heart and re-shape their philosophical approach to securities lending, ensuring that fund investors retain more of the proceeds. In the meantime, there is no guarantee that any more money will flow to downstream to investors.
