Running An Index ETF Is Harder Than It Looks

April 28, 2017

Securities Lending

If ETFs face an unfair benchmark in the perfect math of the indexes they track, they have one thing up their sleeve that no index includes: securities-lending revenue.

Depending on how much the market wants to borrow a particular ETF’s holdings, revenue from a well-run securities-lending program can add tens of basis points a year to the bottom line, often overwhelming the impact of the expense ratio.

Securities lending can be controversial.

BlackRock, for instance, is known for having an aggressive securities-lending program, managed by an in-house team. It takes 30% off the top and gives 70% of the revenue back to the funds. Most other firms outsource securities lending to a third party, and remit 100% of the “profits” to funds. In either case, it can make a huge difference, for very minimal risk.

Measuring Impact

So how do you know whether your fund manager is “good”? For the most part, ETF issuers are very good at what they do, and there’s a reason we take all of the accounting and compliance and corporate actions work for granted—because it’s extraordinarily rare for any ETF or mutual fund manager to mess these things up.

The more subtle things—the trading and the securities-lending activity—show up in performance directly, and you can measure it with tracking difference. Here’s the Tracking Difference panel for the iShares MSCI Emerging Markets ETF (EEM):



If the fund were “perfect,” you’d expect the fund to be exactly 70 basis points behind the index it’s tracking—because that’s how much the manager takes out of the fund in fees.

But this panel suggests that in a median 12-month period, over the last two years, the fund is only behind by 62 basis points. That means 8 basis points are in your favor as an investor, likely from trading activity and securities lending.

In the best-case scenario, you were only behind by 33 basis points—meaning you were 47 basis points better off than you expected. And in the worst-case scenario, you were just 7 basis points off worse than expected.


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