Investors are turning to exchange-traded funds (ETFs) in ever-growing numbers. At the end of August, total global ETF assets hit a new record — US3.343 trillion and, here in Canada, assets have grown by a whopping 25.3% this year alone. A big driver of growth in the ETF space has been their low costs – a major draw for investors grappling with low returns. But as ETFs become more ubiquitous, how has the profit model evolved for providers?
A new paper takes a closer look at how ETFs generate revenue beyond the low fee model. In their paper, “Two-Sided Markets in Asset Management: Exchange-traded Funds and Securities Lending,” Robert Whaley and Jesse Blocher from Vanderbilt University take a closer look at the growing role securities lending plays among ETF providers. Their paper will be presented at the Northern Finance Association Conference being held in Mont Tremblant, Quebec, from September 16-18 2016.
While it should come as no surprise that securities lending is part of the ETF space, Whaley and Blocher examine how much revenue is being made from the practice and whether or not it drives securities selection.
The authors propose that the ETF industry’s rapid growth has come from leveraging a two-sided market model, with revenue drawn from investors on one side and stock borrowers on the other. In many cases fees from securities lending are higher than those that come from their investors. Looking at the ratio of revenues between lending and direct fees for ETFs between January 2009 and December 2013, the authors find the following:
While the value-weighted annual expense ratio of passive investment funds in our sample is 26 basis points, ETFs make 23-28 bps per year from securities lending.
Moreover, firms can seek to optimize their lending fees by holding more profitable securities:
If firms aggressively optimize their holdings to lend only the most profitable-to-lend securities, revenue can exceed 100 bps per year. These securities lending revenues are substitutes for the expense ratio, indicating that ETF providers can fine-tune the ratio of revenues between lending and direct fees.
The interplay between two sources of revenue for ETF providers should be of interest to investors who, as Whaley and Blocher point out, “are no longer the customer buying the service but are the product being sold.”
You can read the full paper here.