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How Some Index Funds Are Beating the Index

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.

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The article How Some Index Funds Are Beating the Index originally appeared on Fool.com.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days . We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy .

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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