ETF

Investing for ‘free’ and Securities Lending

I know it sounds like a clickbait. Promise it’s not.

My last article on securities lending, I have mentioned the possibility of investing for ‘free’ if you choose the right fund. Over a long enough investment time horizon and investing in the right fund, you could potentially be investing for ‘free’.

Generally speaking, efficient index funds with massive asset under management (AUM) that conduct securities lending, are potential candidates to investing for ‘free’. Now, not all index funds with huge AUM can achieve this feat. I will go into details below on how you can screen for potential funds to invest for ‘free’.

How to know if you are investing for ‘free’

When the fund’s GROSS return equal to the fund’s NET return, you are essentially investing for free, excluding your transaction costs of entering/liquidating the position and taxes. Typically, this would only happen over the long run with more than 10 years of track record.

The next natural question. Why?

When an index fund is efficient at tracking its benchmark, the fund’s gross return would be equal to the benchmark’s gross return. The fund’s net return would then be calculated by taking fund’s gross return minus by the fund’s Total Expense Ratio (TER).

Net Return = Gross Return – TER

TER is the total operating cost of managing a fund which includes management fees, custodian charges, legal fees, trading costs, etc.

Now, how can the gross return equal to the net return when we are subtracting the TER from the gross return?

That is where the ‘magic’ of securities lending comes in. As mentioned in my last article, securities lending generate additional income for the fund.

This additional income boosts the gross return of the fund and if the amount of additional income generated from securities lending equals to the TER (in dollar value), the effective TER is 0%. In other words, you are investing for ‘free’, since the cost of investment is 0, excluding transaction costs and taxes.

Now if the amount of income generated from securities lending is less than the TER (in dollar value), the effective TER that you would be paying would be LESS than the advertised TER. You are not exactly investing for ‘free’ in this scenario but nevertheless, a good outcome.

Screen #1 Look for index funds and not active funds

This phenomenon is more prevalent among efficient index funds. Keyword being efficient. Mainly because the objective of an index fund is to track its underlying benchmark and an efficient index fund does a pretty good job of doing that. An inefficient index fund would have a high tracking error, i.e. it does not track the benchmark very well.

An efficient index fund would have a very low tracking error and a very low active share as well.

The objective of an active fund is to outperform the benchmark and not to mirror it. Generally speaking, an active fund would have a high active share compared to an index fund. In other words, actively managed funds are not what you should be looking for if you are interested to look for funds to invest for ‘free’.

Active share measures the percentage of the fund that differs from the benchmark. The higher the active share, the more significant the differences in securities holdings between the fund and the benchmark.

Tracking error measures the return divergence between the fund and the benchmark.

Note that there are ‘fake’ active funds out in the market that tries to pretend to be an active fund. But in reality, their holdings do not differ very much from the benchmark holdings. Funds that try to pretend to be an active fund tend to have a low active share. These funds are known as a closet indexer.

As a rule of thumb, funds with less than 60% active share are potential closet indexer.

Not all active funds with low active share are closet indexer.

For more information on active share, refer to the attached research paper by Fidelity Investment: Fidelity Investments – Active Share

In general, real active funds cost more to invest than index funds, i.e. all things equal, active funds generate more revenue than index funds for the fund issuers. Now you know the reason why some active managers are closet indexers.

Screen#2 Look for funds that conduct securities lending

Since the secret sauce to investing for ‘free’ is the act of securities lending to generate additional income to offset the TER, naturally, funds that conduct securities lending would offer investors a higher probability of achieving this objective.

For more information on how to find out if your investment funds conduct securities lending, refer to the last section of my last article.

Screen#3 Look for the absolute cheapest of the cheaps

Since we want the revenue from the securities lending operation to offset the fund’s TER, naturally funds with a lower TER would have a lower revenue target to hit to offset the TER, as compared to a fund with a higher TER which would have a higher revenue target.

Now for broad market exposure, I would advocate going for absolute cheapest of the cheaps. For example, if you are looking for broad market exposure to the US market, looking for funds that track the S&P 500 Index would be a good choice.

Some example of ETFs that track the S&P 500 Index includes SPY, IVV, VOO. As of August 2019, they cost 0.09%, 0.04% and 0.03% respectively. In terms of the underlying securities holdings between the 3 ETFs, you are getting the same exact exposure.

While there are some nuances between the 3 ETFs, buying them in the market would not be an issue as the trading volume for these ETFs is huge. Holding these ETFs over the long run would not be an issue as well, as these funds are issued by established fund issuers and therefore the fund closure risk is very low.

Investing in VOO ETF would offer an investor the highest probability of investing for ‘free’. Though investing in IVV and SPY would be good as well, just note that their TER is slightly higher than VOO.

As a result of the higher TER, SPY and IVV would have a higher securities lending revenue target to hit to achieve an effective TER of 0%, as compared to VOO.

Screen#4 Look for funds with at least 10 years of track record

If the fund has been consistently tracking its benchmark efficiently over a period of 10 years, there is a good chance that the fund can continue to do so in the foreseeable future. Note that if the benchmark performs badly, an efficient index fund would also perform badly.

For example, the iShares Core S&P 500 ETF (IVV). I have provided a screenshot of the performance table below which display the NAV and the benchmark (S&P 500) performance.

IVV performance

You might notice that the 10 Years NAV and the benchmark performance is coming in at an annualised rate of 13.15%, as of 28 August 2019. NAV performance numbers are net of fees that have been accounted for TER.

If you have been investing in IVV for the past 10 years or so, you have been investing for ‘free’, excluding any transactions costs of opening/closing the position and any taxes that may be incurred.

For more information on IVV, see https://www.etf.com/IVV

For SPY, see https://www.etf.com/SPY

For VOO, see https://www.etf.com/VOO

Conclusion

To be absolutely clear, you should not invest in a fund solely because there is an opportunity for you to invest for ‘free’. Investment consideration should take into account your risk tolerance, time horizon, liquidity requirements, etc.

A fund’s potential to invest for ‘free’ should be viewed as an additional perk feature of a fund. Not as a key consideration.

As always, take personal responsibility of your financial well-being and do your own due diligence.

 

 

Disclaimer: This article does not constitute a solicitation to buy/sell any securities that may be mentioned in this article. At the time of writing and publication, the author does not hold any position in any of the securities mentioned in this article. I am writing in my personal capacity and my views do not represent that of any organisations.  

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