Securities lending: the next bubble?

So it goes something like this: you buy units of an ETF, which holds securities on your behalf. Then the fun begins: the ETF lends your securities to someone who wants to short-sell them, and the ETF charges interest. More money for the unitholder and for the ETF management. Everyone wins, right? Not so fast...

There have been several sobering posts lately regarding this practice of security lending by ETFs. By way of background reading, here are a few good articles by Larry McDonald:

• Securities Lending Wake-up Call
• Two related blog posts here and here
  

Finally, as of a couple of years ago, someone has done the obvious, offering an ETF with a nominal expense ratio of 0%, with management making all their money from security lending.

While this is an obvious triumph of marketing, it scares me. Now, I am not an expert here; I don't know the ins and outs of the regulations surrounding these investment practices. But having said that, the main problem I see is that this scheme doesn't align the interests of the shareholder and management. Management's entire profit comes from security lending, and the profit of security lending can be boosted a few ways, such as, I dunno, lending at higher interest to those with a lower credit rating, or investing the collateral aggressively. Worst of all, while all the potential for profit goes to management, all the risk of loss is borne by the fund investor.

This is a scary situation. You've got a scheme that offers money for nothing with a plausible, if esoteric, explanation ("hey, we're not angels; we make our money from security lending, but don't worry your pretty little head about complicated details like that"); and it does so with a scheme that puts management's interest at odds with the interests of investors. Worse, the kinds of abuses that this scheme invites seem to be the same kind of aggressive lending and investing practices that led to this financial meltdown that some of of you may remember from a few months back.

As usual, Vanguard seems to have their act together on this one. They make their money from an explicit MER, and give all profits from the security lending to the unitholders. This way, the risks of profit and loss go to the same party--the unitholders--and investors know exactly how much they are paying management. I gather Vanguard's seemingly unwavering ethical behaviour stems from the fact that they are actually owned by their unitholders.

Next time you buy an ETF, you might want to consider what they do with the profits and collateral from their security lending operations.

(Please keep in mind that these are just the opinions of a relatively uninformed amateur. Also, I have no financial stake in Vanguard, nor any funds invested with them.)