In a world where zero-fee funds are rising, how are fund managers making money? And while zero fees sound beneficial for investors, is it really the best option?

Marius Zoican, an assistant professor of finance at the University of Toronto Mississauga and Rotman School of Management, tackled these questions in a new working paper.

During his research, Zoican realized funds aren’t only lowering fees by finding back-office efficiencies due to technology, they’re also generating revenue from security lending fees charged to short-sellers.

For instance, some marijuana exchange-traded funds in Canada are paying dividends even though the underlying stocks have no dividends, he notes. “And then when I read the disclosure of those funds, it seemed like all the revenues came from security lending because there were a lot of people out there, a lot of the investors, willing to short these stocks — these weed stocks — because the volatility is very high. And because they are willing to short them they were borrowing them from ETFs and paying the lending fees.”

Investors may be better off receiving security lending revenues as a dividend rather than a fee discount, says Zoican. “And the intuition here is the following: when people want to borrow securities from funds, that’s when they want to short them and that’s because they have some sort of negative information about the stocks.”

This means that they’re going to pay a dividend from securities lending when the stock price is expected to decrease, he notes. “So you’re going to have a little bit of a hedge.”

One problem is that securities lending is not very transparent, so investors may not be aware if the fund is doing it, he adds.

And the paper found there’s no incentive for funds to disclose security lending revenues.

However, it’s more optimal than just offering blanket zero-fee funds, says Zoican, noting investors are generally risk-adverse. “They don’t want to experience the ups and downs of the stock market to their fullest. Now when you get a dividend, you get a higher dividend when security lending activities are the highest. Well, security lending activities are the highest when a lot of people want to borrow securities and the majority of security borrowing going on is when people want to short.”

As well, the findings suggested there’s still room for cost-efficiency improvements, even if the zero-fee point is reached and there can still be further automation in the universe of passive investment.

“Now, the problem is that costs have been decreasing very much in the past years and, if they reach zero, if the fees reach zero, then the funds basically capture all the extra benefits from efficiency because they’re not going to start offering money for you to invest in that,” says Zoican. “So the zero limit acts in some ways as a bound; you cannot go below zero. So any further efficiency improvement will be captured by the fund itself.”

Looking beyond zero fees is also important for competition, because fees used to be one way for passive funds to differentiate themselves. “Now that fees are going to zero, they’re going to try to offer new services,” he says. “And sharing their security lending revenue is one of these new services. They will try to out-compete each other to offer something new.”

Zoican presented the paper at the Northern Finance Association conference in Vancouver in September.