Monday, November 9, 2009

Some Index ETFs Understate Fees

Until recently, the leader in index ETFs for U.S. stocks has been Vanguard. Their great reputation combined with rock-bottom MERs has made them the clear choice. However, Schwab has come out with several index ETFs with management fees matching or beating Vanguard with the added bonus of paying no commissions when trading in a Schwab account.

Some ETF companies generate extra revenue through securities lending. This is the practice of lending stock to short sellers for a fee.  Some commentators are speculating that Schwab is keeping the proceeds from securities lending to augment the MER. The Schwab prospectus doesn’t seem to clear up the matter:

“When the fund lends portfolio securities ... the fund will also receive a fee or interest on the collateral. ... The fund will also bear the risk of any decline in value of securities acquired with cash collateral.”

So the fund gets a fee and the fund bears the risk. What do they mean by “fund” in this context? Is it the unit-holders or the management company?

In my opinion, because unit-holders own the securities they should keep the proceeds of securities lending (net of reasonable costs). If a management company keeps some or all of the proceeds, then they are essentially understating the fund costs.

Until Schwab makes it clear who gets the securities lending proceeds, I’ll stick with Vanguard. Vanguard has a clear policy:

“Unlike other firms that allocate a significant portion of lending revenues to their management companies, Vanguard returns all lending revenues, net of broker rebates, program costs, and agent fees, to the funds. Other securities lenders may divert up to 50% of the revenues derived from their securities lending programs.”


  1. Thanks for the post.

    A typical investment company like Schawb is trying to maximize profits for its shareholders through whatever methods possible. Sometimes these methods come at the expense of its clients, those who invest in the company's ETFs and funds.

    This is a good example of why I like Vanguard. As I understand it, when you own Vanguard ETFs or funds, you also own a part of Vanguard. This way, you eliminate competing interests between the Vanguard company shareholders and the owners of the Vanguard ETFs and funds since they are the same people.

  2. Blitzer68: I'm a fan of Vanguard as well. I'm not ready to write off the Schwab ETFs yet, but I'll stay away until I understand them better.

  3. Michael - I like your idea of counting it against the fund company when they skim profits from securities lending. That really ought to be included in the MER. I think that would remove the conflict of interest that is otherwise inherent in securities lending.

    There are already rules about what must be included in MER, and if the company's share of securities lending revenue is not included, it should be!