Index investing is popular because it is a low-cost, often tax-efficient way to invest in the stock market. Index funds forgo costly analysts and portfolio managers, and instead build their portfolios so that the fund mirrors the stock holdings in an index.
The basic premise is simple: The average actively managed fund will generate the return of a stock index minus fees. If you minimize fees by minimizing active management, you can maximize returns to the investor.
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Vanguard's Small-Cap Index Fund (VB 1.48%), for example, simply buys and holds stocks in the same proportion of the Russell 2000 Index. Its results, then, should match the results of the index, minus fees. But something interesting is happening -- it's actually beating the performance of the index it should theoretically lag.
Profiting from short-sellers
A recent Bloomberg article points to a somewhat obscure business many fund managers participate in: securities lending. Securities lending is really quite simple. When another investor -- most commonly, a short-seller -- wants to borrow stock, he or she must find the shares to borrow. The owner who supplies the shares collects a fee (interest) for lending the shares.
Vanguard's financial filings reveal that securities lending has been particularly profitable for Vanguard's small-cap funds. In fact, income earned from securities lending completely covered its funds' fees and expenses of its small cap funds. See the snippet below, which highlights securities lending revenue and the total expenses of the Vanguard funds.
Last year, the many Vanguard funds that track this index generated about $48.5 million in securities lending income. Combined fund fees and expenses -- which even includes the cost of printing and postage for the funds' annual reports -- tallied to just $45 million.
In effect, the funds paid their investors to own them, and thus Vanguard's Small Cap Index ETF has beaten its benchmark for several years running.
The ups and downs
There is no such thing as a free lunch, though. Securities lending injects some additional risk into an index fund. The borrower's collateral may not be sufficient to cover losses in the event the borrower becomes insolvent. (ETFs typically request collateral equal to 102% to 105% of the securities they lend, though market movements can result in collateral that is insufficient to repay the loan in the worst case scenario).
In addition, cash collateral received from securities lending is often invested in money market funds, which injects another layer of risk. Over time, however, securities lending has proven to be quite profitable. Losses, should they occur, are more than made up for by the interest earned on securities loaned out.
Vanguard explained in a note that it tries to minimize risk by lending to select broker-dealers, and by using "strict guidelines" as to how much can be loaned to any one counterparty.
Ultimately, securities lending may make investing completely fee free. In 2013, Nick Blake, head of retail at Vanguard Investments, told the Financial Times that "I would like to think the cost of investing [in ETFs] could come down to zero."
This year, Vanguard introduced an institutional fund that charges its investors just 0.01% on their investment each year. With modest securities lending income on top, it's not hard to see how that fund could easily pay its owners to hold it.
The investment landscape is changing rapidly. As fees come down and funds become more creative and transparent about how they can further minimize costs with ancillary activities like securities lending, all investors benefit. This truly is a new age. Investing has never been this easy, or this inexpensive.
