Expense ratios for index mutual funds, especially ETFs, may not come anywhere close to revealing the fund sponsor's real revenues from the fund.

That's the thrust behind new research from a pair of professors at Vanderbilt University's Owen Graduate School of Management. Jesse Blocher, assistant professor of finance, and Robert Whaley, Valerie Blair Potter professor of finance, looked into mutual fund shops' securities lending revenues.

"We decided to take a crack at how much they're making," Blocher tells MFWire. "We decided to take a crack at how much they're making. Nobody can really figure out how much any mutual fund is making from securities lending."

Blocher says that securities lending is becoming more and more popular with index mutual fund firms, especially with those that run ETFs. He says that fundsters often say that some securities lending money is returned to investors in the funds and that some is used to fight tracking error.

"We can't really confirm that they're doing that," Blocher says. "We don't find any correlation between securities lending and tracking error."

Blocher and Whaley looked at funds' actual holdings (they have more ETF data, thanks to daily disclosures), then used securities lending fee data to estimate how much money the funds' sponsors could be making from their funds, based on restrictions like the '40 Act (which prevents funds from lending out more than 50 percent of their portfolios). Active managers, Blocher says, traditionally haven't wanted to engage in much securities. Yet Blocher and Whaley estimate that ETF and index fund sponsors could be making two to four times their funds' expense ratios in securities lending fees, with about 30 percent of that being returned to investors in the funds.

"If they're being aggressive about, it could be five to seven times the expense ratio," Blocher says.

Blocher and Whaley avoid making moral judgments on fundsters' securities lending practices. Blocher says he and his colleague just want "more disclosure, more transparency about what's going on."

"Investors should have a choice," Blocher says, noting that prominent ETFs, like SSgA's SPY, use a UIT (Unit Investment Trust) structure, which is prohibited by statute from doing any securities lending.

Looking ahead, Blocher says that he and Whaley are working on more securities lending research related to put-call parity. And Blocher also will soon be looking into active fundsters' possible use of ETFs instead of cash. 

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