The Fee the Expense Ratio Misses

Financial advisors spend a great deal of time comparing fund expense ratios, and for good reason. Costs compound, and even small differences matter over time. But the expense ratio does not always capture the full costs of owning a fund.

Securities lending is an excellent example. A mutual fund or ETF may temporarily lend stocks or bonds from its portfolio to a broker, usually to facilitate short selling or market making. The borrower posts collateral and pays for the loan, creating income from securities the fund already owns.

I remember sitting near a high yield portfolio manager years ago when he discovered that bonds he wanted to sell had been lent out. The market was moving, the sale pertained to a name in some distress, and he was furious that the fund could not immediately deliver the securities. The bonds were still legally owned by the fund, but operationally they were somewhere else, and the portfolio manager had to wait for them to come back.

That episode stayed with me because it captured a trade-off. Securities lending can create extra income, but the fund gives up some control over the lent assets while the loan is outstanding. If the security cannot be recalled quickly enough, the cost may show up as a failed settlement, a delayed sale, or a missed opportunity rather than as a line item in the expense ratio.

To be clear, securities lending can add value for shareholders, and operating a lending program requires work. Borrowers must be approved, loan rates negotiated, collateral monitored, and securities recalled when the portfolio manager wants to sell or vote them.  Often, a lending agent handles this.

The conflict arises when the lending agent is affiliated with the fund’s investment adviser.

The adviser helps to oversee how much of the portfolio is available for lending and how aggressively the program is run. At the same time, an affiliated lending agent may earn more as lending activity and revenue increase. The adviser helps control the activity while an affiliated company, and thus the adviser, participates in the profits.

Such compensation may be deducted from securities lending revenue rather than reported as an operating expense in the headline expense ratio. The arrangement is disclosed, but it’s easy to miss because the cost appears as income that never reaches the fund rather than as a visible fee.

Consider a simple example. A $1 billion fund reports an expense ratio of 0.10%, equal to $1 million per year. It lends $100 million of securities and generates $250,000 of income before compensating the lending agent.

If an affiliated agent retains 20%, it receives $50,000 and fund shareholders receive $200,000. Securities lending adds two basis points to the fund’s return, but without the revenue split it would have added two and a half.

The fund can still report an expense ratio of 0.10%. The additional half-basis-point cost may not appear in the number advisors use to compare it with competing funds, even though it reduces the income reaching shareholders and benefits an affiliate of the adviser.

This is not a rare arrangement. SEC data show that 4,837 of the 5,534 funds reporting securities on loan in 2025 also reported a revenue-sharing split with a lending agent or collateral manager.

I’d be less concerned if the fund were divvying up a risk-free windfall; however, as I witnessed firsthand, this is not the case.  Securities lending exposes the portfolio to counterparty default, collateral reinvestment illiquidity, operational errors, and failed recalls.  As an FRM holder I am particularly sensitive to these risks.

Fortunately, information is available, generally in the fund’s Statement of Additional Information, including gross lending income, borrower rebates, agent compensation, collateral-management costs, and the amount retained by the fund. But it is far less visible than the expense ratio shown in the prospectus or on a fund comparison screen.

The question is not whether securities lending is good or bad. It is whether the adviser has created the right incentives, whether shareholders receive a fair share of the income, and whether the risks taken on their behalf are justified by what they keep.