With MERs (Management Expense Ratios) being very low on index tracking ETFs (for example Vanguard charges a piddly 0.07% MER on VTI – Vanguard Total Stock Market Index ETF), you wouldn’t think there could be ways to offer still cheaper ETFs.
Did you know there is now an ETF out there with an MER of 0.00%? Don’t believe me? Then click here to learn more about the db x-trackers DJ Euro Stoxx 50 Index ETF. (You may have to click a box to accept the terms for use of the website and then reload the page.)
Of course, if anyone actually believes that this ETF is not designed to make the company money, you are unfortunately mistaken. Part of the reason they can charge a 0.00% MER is that the revenues from securities lending more than offsets the cost of running the fund. Securities lending means the fund lends out stocks in the fund to short-sellers (who need to borrow stocks in order to short sell them). The fund collects interest on the lending of these stocks.
This is exactly what Larry MacDonald had proposed (tongue in cheek) in a blog post of his some time ago…
Very cool and smart idea. I’ve always thought that giving people something for free is often more profitable than charging people for the same activity.
I’m always suspicious of a free lunch. Presumably it is possible for a stock to gap up in price, and the short seller is unable to meet the margin call. Do the holders of the index lose in this situation? If not, who does?
@Michael James – Your skepticism is warranted. The custodian providing the short selling abilities has no liability, and the fund has no liability. So if a short seller is unable to meet their obligations, the counterparty risk manifests itself in losses to the fund and hence the unitholder. There are certain provisions required for short sellers, such as they are required to post 102% collateral which must be money market “or similar” securities in most cases, but nonetheless, any risk is born by the unitholder (usually unbeknownst to them).
If I’m going to carry the lender’s risk, then I would rather pay a nominal MER and take distribution on the interest income.
@Preet – the short seller is “Deutsche Bank AG” (detailed perspectus page 31). The default risk is pretty low considering if the bank defaults on you the fund you are holding will be worthless anyways. If they change their short selling policies and allow others to short sell those shares then the risks would certainly mount.
The main problem with this fund is that you cannot purchase it unless you live in Germany. As has become very standard Canada is a loooooong way behind the curve in unique investment tools (unless overcharging on MER is unique).
@Preet – I looked into this a little deeper. This is not a fund that deals with short selling at all. This is a swap selling system. Basically You invest x amount in the fund. The bank takes x amount of dollars and invests it where they want and guarentee you a return matching that of the index the fund tracks. Then if the bank does better than the fund they pocket the extra money, if not they chip in the difference. The actual assets purchased cannot exceed a +-10% difference between the index and the actual value. Otherwise this fund is in essence a glorified loan to the bank.
Its a very interesting idea that some of my smarter clients have been using for years when doing investing. With this system you actually have a better return than is typical (at or even slightly better than the index). The risk side is if the bank doing the swap arrangement goes caput then you loose some (or all) of your money. This is mitigated by the 10% requirement, actual assets under management will never be more that 10% from the promised value.
@Ink-Stained Gorilla: many ETFs engage in securities lending, and in each case the investor carries the risk (and most don’t know it). Barclays earned about $750 million in securities lending last year, with about 20% of that coming from their ETFs. Securities lending fees in actively managed funds occurs as well. Could be a good story to look into. Some securities lenders share the revenues with the fund, some do not.
@Cam Birch – we’re talking two totally different things. The x-trackers is a 90/10 synthetic replication ETF structure: 90% holding actual stocks, and 10% holding forward index contracts (or a series of forward contracts, known as a swap). This structure has nothing to do with their securities lending practices. Of the 90% of the fund that actually holds underlying stocks, they can lend these out to short sellers (external to the fund, the fund is not short selling) and charge them interest. Part of this interest collected is used to offset the cost of running the fund + profit.