# Vanguard Canada lowers fees on 11 ETFs



## yupislyr (Nov 16, 2009)

Looks like the ETF competition heats up in Canada a little more as Vanguard Canada lowers some of their ETF fees, as was probably expected

From the press release


VCE 0.05%, old 0.09%
VCN 0.05%, old 0.12%
VDY 0.20%, old 0.30%
VFV 0.08%, old 0.15%
VSP 0.08%, old 0.15%
VDU 0.20%, old 0.28%
VEF 0.20%, old 0.28%
VEE 0.23%, old 0.33%
VAB 0.12%, old 0.20%
VSB 0.10%, old 0.15%
VSC 0.10%, old 0.15%


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## mrPPincer (Nov 21, 2011)

Nice! Great news


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## My Own Advisor (Sep 24, 2012)

Wow, nice work.


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## larry81 (Nov 22, 2010)

Go Vanguard, Go Vanguard !!!

I have no sympathy for the investors who purchased ZCN because of the lower MER. BMO (like any bank) are opportunistic scums.

Vanguard is THE ONLY low cost alternative for the individual investor.

_* sip more vanguard flavored kool-aid_


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## pwm (Jan 19, 2012)

Nice. Thanks for posting. Just so happens that I bought more VDY last week and more VEF today.


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## uptoolate (Oct 9, 2011)

we'll take it!


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## leeder (Jan 28, 2012)

Too bad they didn't lower their fees for VUN, but I guess the Vanguard folks have to do what they think needs to be done to remain competitive...


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## slacker (Mar 8, 2010)

Sweet.

VCE vs XIC vs VCN, which one would you hold?


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## Moneytoo (Mar 26, 2014)

larry81 said:


> Go Vanguard, Go Vanguard !!!
> 
> I have no sympathy for the investors who purchased ZCN because of the lower MER. BMO (like any bank) are opportunistic scums.
> 
> ...


What I don't understand is why VCN's yield is the lowest of the three ETFs that hold the same baskets of stocks - here're the latest prices and yields:

VCN $29.35 1.6%
XIC $23.06 2.43%
ZCN $19.69 2.59%

We don't own any at the moment, but will probably just buy ZLB (despite its higher MER and lower yield) Have been watching them for a while, ZLB is definitely less volatile, and we already have some individual stocks (financials and oil) that it doesn't have, so looks like a better fit for our portfolio...


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## james4beach (Nov 15, 2012)

Wow. Someone remind me again why anyone puts money into mutual funds?


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## humble_pie (Jun 7, 2009)

wondering why folks are so ecstatic?

the ETF vendor has gone to indexation, is all. It's the big vogue in the ETF industry. 

it means drop the stocks. Stocks have all those irritating costs like custodial fees that get charged every time an index "re-balancing" is carried out. Stocks also have those unpleasant commissions to buy & sell as part of a re-balancing exercise.

what a drag. Stocks are so yesterday. So awkward. So expensive to administer. Eeeeuw.

go hold an index instead. Find some index being run by a twenty-something with a head full of algos. 

there's a thread nearby with details on SDIV & XIC, by way of illustration. SDIV looks like it was built on an index from the get-go, whereas XIC flambuoyantly dropped its MER to one-half of one percent recently, presumably when it got index-happy.

i know i know. People do *not* want to hear that their rock-solid retirement fund equity ETFs aren't really holding any common stocks, they're holding derivative bunches of algos instead.


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## GoldStone (Mar 6, 2011)

^ WADR, what a bunch of nonsense.


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## My Own Advisor (Sep 24, 2012)

james4beach said:


> Wow. Someone remind me again why anyone puts money into mutual funds?


+1


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## madMike (Feb 10, 2012)

slacker said:


> Sweet.
> 
> VCE vs XIC vs VCN, which one would you hold?


Cdn Couch Potato recommends VCN, for what it's worth. Or is it XIC? I sold VCE in Aug. to get to VCN (tracks entire TSX, not just 70-80 stocks). Haven't bought back in yet - nice bit of market timing I know...I'm brilliant not lucky. Was tempted to sell off VTI and VXUS too...but held off. Can't be a true Couch Potato if ya market time...


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## Soon Forget (Mar 25, 2014)

Moneytoo said:


> What I don't understand is why VCN's yield is the lowest of the three ETFs that hold the same baskets of stocks - here're the latest prices and yields:
> 
> VCN $29.35 1.6%
> XIC $23.06 2.43%
> ZCN $19.69 2.59%


I believe this is because VCN has the fastest growth rate right now - it's the newest/smallest fund of the three and has the greatest proportional amount of new $ flowing into it. As new money enters the fund and new shares are created, the distributions are diluted across the new shares thus the lower yield. But, this lower distribution is also reflected as a higher share price... so it really makes no difference to the final monetary value. Canadian Couch Potato wrote an article about this at some point.

As VCN grows further it's yield should start to match the others.


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## HaroldCrump (Jun 10, 2009)

humble_pie said:


> go hold an index instead. Find some index being run by a twenty-something with a head full of algos.
> ...
> i know i know. People do *not* want to hear that their rock-solid retirement fund equity ETFs aren't really holding any common stocks, they're holding derivative bunches of algos instead.


You are on the right track.
All ETFs should simply convert to *total return swaps *with a counterparty and trade as ETNs.
The counter-party should be a secure, well capitalized, tax-payer backed institution such as umm...for example, AIG or Deutsche Bank.
What could go wrong?


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## Beaver101 (Nov 14, 2011)

My Own Advisor said:


> +1


 ... -1 :biggrin:


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## slacker (Mar 8, 2010)

humble_pie said:


> wondering why folks are so ecstatic?
> 
> the ETF vendor has gone to indexation, is all. It's the big vogue in the ETF industry.
> 
> ...


Holy cow, XIC was not an index fund prior to the fee drop? Is that true?

XIC does not hold stock, but instead is a derivative ? Is that true?

This is not my understanding. Can you have specifics on these assertions?


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## humble_pie (Jun 7, 2009)

GoldStone said:


> ^ WADR, what a bunch of nonsense.



wadr bunch of nonsense is an oxymoron

gold u can write better than this :biggrin:


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## humble_pie (Jun 7, 2009)

HaroldCrump said:


> You are on the right track.
> All ETFs should simply convert to *total return swaps *with a counterparty and trade as ETNs.
> The counter-party should be a secure, well capitalized, tax-payer backed institution such as umm...for example, AIG or Deutsche Bank.
> What could go wrong?



yes i do believe i'm on the right track.

but i'm used to the flaming by now. I mean, this is the 3rd revolutionary idea i've introduced to this forum. Each time there was ugly, furious, incendiary flaming at first.

but each time, within a few years thousands of investors eventually learned to benefit. Take the concept that all the brokers are charging FX fees upon all of the dividends from about 20 big important companies that pay USD divvies.

when i introduced that idea a few years ago, the only people in cmf forum who believed me were haroldCrump, toronto.gal & kcowan.

CC & i would occasionally exchange pmms about how difficult it was going to be to teach people about this fairly substantial ripooff that the brokers were conducting.

but flash forward a few years & now the big green reps tell me that they have hundreds of investor clients phoning them to request journalling of the 20 canadian stocks over to USD account, to avoid the broker FX fee on the dividends. Whereas 3-4 years ago one could not find a broker licensed representative who had even heard of the issue, today it's commonplace. Today the broker reps know to cooperate very gladly.

so now i'm starting on the research that increasing numbers of ETF vendors are selling, not actual collections of bona fide exchange-traded stocks that in the aggregate form an index, but rather they are selling cheap derivatives of such index, which their prospectuses allow them to do.


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## james4beach (Nov 15, 2012)

humble_pie said:


> wondering why folks are so ecstatic?
> 
> the ETF vendor has gone to indexation, is all. It's the big vogue in the ETF industry.
> 
> it means drop the stocks.


Like humble, I'm cautious about the possibility this is happening. This is why I always say to wait until you see audited annual financial statements for an ETF.

Like any other ETF, with these vanguard changes I would want to wait until year-end financial statements are out. Then I would check, in detail, the list of assets and break-down of investments to see exactly what they hold. Checking the web site for holdings isn't enough, because with index derivative based investments the web sites still show the index constituents.

You've got to wait to see the audited statements. I know, waiting (and reading) is boring


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## HaroldCrump (Jun 10, 2009)

James4B, it will not be enough to review the annual statement of the ETF vendor.
Those will be nicely audited by one of the Big 5 accounting firms, squeaky clean and pristine.
You will have to review the financial statements of their counter-parties, such as Deutsche Bank, Credit Suisse, etc.
That is where the risk lies.

If you attempt this, you will become Alice in the Rabbit Hole...you can keep following these counter-parties all across the globe.
From the ETF vendor to a US insurer to a European bank like Deutsche to a Japanese financial conglomerate like Mitsubishi, to some Chinese bank with these new-fangled "wealth management" products.
Before long, your head will be spinning.


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## james4beach (Nov 15, 2012)

Harold, I've gone down that rabbit hole long ago.

There is still tremendous value in reviewing the public financial statements. At the very least it tells you, structurally, how the ETF is set up. It will show you whether they hold index derivatives or actual stocks.

The financials also show you the extent of the securities lending that the fund engages in. These are somewhat hidden, but it's still buried there in the notes. This is where you start to worry about counterparties etc. You're right, these are all big concerns.

But as a starting point, you should absolutely find out what the fund holds and whether you're dealing with a derivatives beast.


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## humble_pie (Jun 7, 2009)

a good example of representational sampling via index derivatives is probably vanguard's VWO.

this emerging markets ETF reportedly (fact sheet) holds no less than 962 actual stocks, some on corrupt, challenging, dysfunctional stock exchanges such as morocco, where the very existence of an alleged common stock is difficult to determine & the sheer costs of reputable custodianship would run close to 1% of capital.

yet VWO claims that for these 962 stocks, many held on similarly primitive & dysfunctional exchanges all over the planet, its MER is only .15%? what kind of naif is going to believe that?

in my searches so far, the only ETF company i've come across whose representatives will say honestly, straight out, that their flagship ultra-low-cost HXT & similar structures are holding 100% swapped derivatives, is Horizons BetaPro. Of course, their fund fact sheet does list a hokey-schmokey bunch of top canadian "stocks" as HXT holdings, but at least the reps know to explain that those are only representational. They'll tell you honestly & straight out that what HXT holds are derivatives with the national bank.

we can see in the nearby SDIV thread - there's detailed, complicated prospectus analysis on there - how smart math whizzes are selling their services as bespoke index custom tailors. An ETF provider wants to dump its stocks & cheaply hold a forward swap instead? fine, they'll build you one.


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## james4beach (Nov 15, 2012)

humble_pie, I share your skepticism about VWO. It doesn't seem to add up. These are not easy markets to access. Their annual financials do mention futures:



> The fund may seek to enhance returns by using futures contracts instead of the underlying securities when futures are believed to be priced more attractively than the underlying securities


They say that at 2013 year end, futures represented less than 1% of net assets. Now we get into tricky territory as futures are leveraged instruments, and we don't know the leverage on these. For instance if they're 20:1 instruments, then VWO could have less than 1% futures by net assets, *but* futures might represent 20% of the effective composition of the fund. In other words they could hold 80% or less in actual stocks.

In any case, once derivatives enter the picture, everything becomes murky. And you're right that derivatives are becoming pervasive in the ETF industry.


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## humble_pie (Jun 7, 2009)

a fund could not hold futures 363 days of the year, then drop out on day 364/penultimate trading day, so it can say in its annual snapshot that at year's end it was holding only 1% futures?

Edit: in fund lingo don't they call this window-dressing


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## james4beach (Nov 15, 2012)

They certainly could be doing that, humble_pie and I wouldn't put it past them.

I'm also pointing out that "1% futures" may itself be a huge exposure equivalent to more like 20% actual, due to the intrinsic leverage of futures and the lack of transparency about how they are calculating that. For instance the 1% figure may only refer to the maintenance margin of the futures position. And yeah, the overnight/maintenance position is really small in dollar terms. However it represents a HUGE futures position.

Disappointing that ETFs are losing transparency with time. Too much financial engineering, too much derivatives, too many games. I like ETFs but only plain vanilla ones, and they're getting harder to find.


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## GoldStone (Mar 6, 2011)

*VWO Investment strategy and policy:*



> Investment strategy
> 
> Vanguard FTSE Emerging Markets ETF is an exchange-traded share class of Vanguard Emerging Markets Stock Index Fund, which employs a “passive management”—or indexing—investment approach by investing substantially all (normally about 95%), of its assets in the common stocks included in the FTSE Emerging Index *[1]*, while employing a form of sampling to reduce risk *[2]*. The FTSE Emerging Index is a market-capitalization weighted index representing the performance of large and mid cap companies in emerging markets such as Brazil, Russia, India, Taiwan, and China.
> 
> ...


My notes:

*[1]* Substantially all (~95%) of the fund assets are invested directly in common stocks. You can easily verify this by looking at their quarterly/annual reports.

*[2]* Sampling does not refer to derivatives. Sampling means they don't have to buy every stock in the target index. They can track the index pretty accurately by owning a certain subset of stocks.

*[3]* Yes, they are allowed to use derivatives. The next sentence in the same paragraph explains why. Here's the chart of VWO daily inflows and outflows:










Note occasional outflows on the order of 500-700 million dollars a day. They cannot sell 500-700M worth of EM stocks on a short notice. Unpredictable daily outflows force them to keep a cash buffer. To minimize the impact of the cash buffer on the fund performance, they are allowed to use derivatives. 

But remember point #1. 95% of the fund assets are invested directly in common stocks. VWO has $68.9 billion in assets under management. 95% of $68.9 billion = $65.5 billion is invested directly.


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## GoldStone (Mar 6, 2011)

VWO most recent semi-annual report
https://personal.vanguard.com/funds/reports/q722.pdf

Page 68


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## cainvest (May 1, 2013)

This thread got quiet all of a sudden ..... 

Nice to see Vanguard still lowering fees.


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## eddyo (Oct 28, 2009)

humble_pie said:


> wondering why folks are so ecstatic?
> 
> the ETF vendor has gone to indexation, is all. It's the big vogue in the ETF industry.
> 
> ...


What does that mean then...... should I be buying Mutual Funds instead???


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## GoldStone (Mar 6, 2011)

eddyo said:


> What does that mean then...... should I be buying Mutual Funds instead???


No. Just ignore the post that you quoted. There is not much substance to it. It's mostly mudslinging.


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## humble_pie (Jun 7, 2009)

mudslinging & posting nonsense are 2 activities i do not engage in!

what i am doing is voicing a healthy skepticism that an ETF such as VWO, which says it holds more than 960 individual stocks in challenging emerging markets around the globe, can possibly be managed for a MER as low as .15%. 

the skepticism says that this ETF can only drop its MER so low by not holding some of the stocks it says it holds as outright common stocks but rather in proxy form.

the same skepticism applies to the growing number of ETF funds that, in a competitive race to the bottom, are lowering their MERs to levels that are not compatible with broker costs for re-balancing/buying/selling all of the securities that they claim they hold, along with custodial costs for the same securities. In many cases, the custodial costs are higher than the brokerage transaction fees.

goldstone, won't you please notice how you contradict yourself:



GoldStone said:


> *[1]* Substantially all (~95%) of the fund assets are invested directly in common stocks. You can easily verify this by looking at their quarterly/annual reports.
> 
> *[2]* Sampling does not refer to derivatives. Sampling means they don't have to buy every stock in the target index. They can track the index pretty accurately by owning a certain subset of stocks.



here you are saying that, yes VWO owns a vast list of common stocks exactly as published. Then in the very next sentence you say VWO doesn't have to buy every stock that it says it holds, all it has to do is sample in order to hold a representative subset of stocks.

in other words, you confirm that VWO does *not* hold the full list of stocks that it publishes in its financial statements. Instead, you say, the fund holds stocks plus proxies via a sampling strategy.

may i ask where you would draw the line with respect to sampled vs non-sampled stocks? in your view, what is the proportion of stocks that should actually be bought & held in custody for the benefit of VWO unitholders? what is the proportion of stocks the fund will claim that it *holds* but which, in fact, are present only via sampled proxies?

do you believe that 60% common stocks in custody vs 40% in proxy/sampled/derivative format should be acceptable? would you be OK with a 50/50 split? how about only 20% stocks in outright ownership, with the remaining 80% present only as sampled proxies aka some form of index derivative?

a specific figure from VWO's last annual audited financial statement - dated 31 october 2013 - caught my eye. It was the annual custodian fee.

the custodial fee for the 960-odd securities with a market value of $69 billion was only $40,325,000. This figure is far too low imho, given that this is an emerging market fund, ie several or many of these markets are notoriously lax, dysfunctional, chaotic or even corrupt.

these negative features mean that sound & proper custody for securities is not only mandatory, it's crucial. Such services are not cheap. North american custodial fees run roughly .50% of market value. Although a giant firm such as vanguard would be able to negotiate a significantly lower fee for itself, nevertheless the higher cost of offshore custody in exotic markets would tend to offset any custodial fee volume reduction they might obtain.

with $69 billion, custodial costs could run $200-400 million per annum. Compared to this estimate, the ultra low $40 million suggests that relatively few actual common stocks are being held in custody, which in turn suggests that VWO is holding a substantial amount of proxy or derivative-based assets that do not require expensive conventional custody.

with over a quadrillion $$ in derivative products said to be awash in the world - that's one thousand trillion dollars in derivatives - it's my hypothesis that more & more of these proxy products are making their way into the fund industry, particularly the ETF sector, as it is a sector where customers are easily attracted by low MERs.

but as the old adages say, There's no free lunch. If it looks too good to be true, it isn't.


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## HaroldCrump (Jun 10, 2009)

It will take a major bank bust to surface this issue out in the open.
Like a Deutsche Bank, RBS, Credit Suisse, etc.
There simply isn't enough tax-payer capital in either Germany or Scotland or even the UK to bail out any of these too-big-to-fail-now-even-bigger banks.
The deposit holders and bond holders will be made whole, but the derivative counter-parties will be cut loose.
The ETF holding that swap derivative will be left with nothing.

The party is great as long as the free drinks are flowing.
Once the barrel is drained, the music stops, and the party is over.
What Buffett said about tides and swimming naked...


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## humble_pie (Jun 7, 2009)

HaroldCrump said:


> It will take a major bank bust to surface this issue out in the open ... The deposit holders and bond holders will be made whole, but the derivative counter-parties will be cut loose.
> 
> The ETF holding that swap derivative will be left with nothing.




in 2008, as financial institutions failed left, right & centre, people were beyond aghast to discover how US banks had sliced up the rotten US sub-prime debt, shredded the scraps sideways & sold them onwards to banks all over the world.

i'm sticking to the knitting here. I'm wondering out loud whether the ETFs that have plunged their MERs to unsupportable levels - levels that cannot tolerate portfolio re-balancing commissions - levels that cannot tolerate sound proper custodial services - i'm wondering out loud whether those ETFs are heavily into the much cheaper derivative & proxy products.

i'm also thinking that there's something amiss with the canadian regulations that govern disclosure by mutual funds & ETFs. Although fund prospectuses do adequately explain how they are permitted to invest according to representational samples, hold futures & other derivative products, nevertheless their marketing literature does not present these facts realistically or accurately imho.

alas, investors rarely read prospectuses. They read the fund factsheets & the marketing literature. There it appears that the ETFs are holding all of their stocks in outright ownership.

me i find this pell-mell rush to worship the idols of ultra-low MERs, without any reflection or analysis whatsoever, to be a bit strange ...


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## GoldStone (Mar 6, 2011)

In other news, Elvis is alive. He is held captive, in a cage, in Vanguard basement. They torture him.

They are also responsible for 9/11.

Make sure to wear a tin foil hat when visiting Vanguard web site. Otherwise the matrix will consume you.

HP, your posts in this thread say more about you than about the subject at hand. Your musings about sampling, for example, show how little you know about the mechanics of indexing. It's really embarrassing.

Google "index full replication". Google "index sampling". Learn the difference between the too. It's indexing 101. You need to learn the basics before you can be taken seriously. For this reason, I'm not going to waste my time refuting the rest of your points.

And yes, I repeat. A bunch of nonsense. Mudslinging. Drive-by smear. Unsubstantiated allegations. Baseless insinuations. Should I tell you what I really think?


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## humble_pie (Jun 7, 2009)

no need to tell what you really think, you've already shown this forum repeatedly - to many members, ever since you joined - what kind of rude abrasive personnage you are.

perhaps you're unable to read accurately? i've said i am wondering. I've said the questions should be raised. I've said that no fund can hold hundreds of stocks in outright ownership - which means expensive custodial services - for a MER that's next to nothing. I've said that possibly such funds are holding proxy substitutes. I have every right to voice these questions.


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## My Own Advisor (Sep 24, 2012)

GoldStone said:


> Make sure to wear a tin foil hat when visiting Vanguard web site. Otherwise the matrix will consume you.


LOL.

Yes, do tell GoldStone...I suspect Vanguard is not the devil? :biggrin:


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## slacker (Mar 8, 2010)

I think humble's message is quite important. That these financial instruments that hold our life savings need more scrutiny and transparency.

But the assertions and complete wrongness on some key issues he cited as support serves to detract rather than support his point.

Key issues:
- humble is wrong on this one: VWO's claim of 95% stock ownership, and index sampling is contradictory and therefore is a lie
- humble has not provided reasonable evidence to support: XIC was holding onto real stock prior to the MER drop, but has now silently turned into a return swap derivative since the MER drop


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## cainvest (May 1, 2013)

Not sure I understand the concern, with VWO stating less than 1% and 0% of net assets for long and short futures contracts, what is the big deal here?


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## PuckiTwo (Oct 26, 2011)

Allow me to come at the issue from the point of a company’s needs/goals to
a) to be competitive and therefore
b) to fight( hold or better increase) for their market share

1. Vanguard quite recently entered the Canadian market with lower MERs than Ishares. One can only assume that with this move it gained market share from Ishares and Ishares lost market share.
2. The German company Solactive which was discussed in thread “International ETF dividend players SDIV” *claims that they are the 3rd largest ETF provider in the USA.* It’s likely that with their “customized approach” they attract quite a range of (new and maybe unexperienced) investors. Nonetheless, if their claim is correct, they MUST cut into Vanguard’s business and market share in the US and elsewhere.
3. If that were the case Vanguard would be forced to react - well, we know that they have cut MERs on certain ETFs to a minimum. Could this be a reaction to a rising competitor?

There is no free lunch. If Vanguard cuts drastically MERs it has to save money somewhere else - be it by
- not re-balancing so often
- not re-balance so accurately
- replacing actual stocks thru indexes
- provide less service
(there are numerous ways to cut cost). Which route Vanguard goes we probably don’t know. BUT it seems necessary to put many????? behind this move and investigate what is behind it.


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## cainvest (May 1, 2013)

humble_pie said:


> alas, investors rarely read prospectuses. They read the fund factsheets & the marketing literature. There it appears that the ETFs are holding all of their stocks in outright ownership.


BTW, wouldn't you be in the same boat if one bought mutual funds, just with higher MERs?


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## andrewf (Mar 1, 2010)

Vanguard's business model is scaling and reducing prices, and otherwise offering few frills. It's working very well for them.


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## GoldStone (Mar 6, 2011)

Vanguard investors collectively own Vanguard. It's effectively a non-profit. Growing asset base leads to higher economies of scale. Economies of scale drive down the fees. Lower fees attract more assets. Rinse and repeat.

Passive asset management is a beautiful business. It has a tremendeous operating leverage. A company that passively manages $10B can easily manage $100B. That's a ten-fold increase in fee revenue, assuming unchanged expense ratio. The cost of revenue goes up as well, but at a much, much slower pace.


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## Cellardweller (Jul 3, 2014)

*What about traditional bond ETFf's?*

The cautionary notes on some newer ETF's being sounded here sound logical to me....after 2008 I have an aversion to derivatives. 

What is your take on the bond ETFs from Blackrock such as XBB, XSB, and XCB? They also come with ten pages in the prospectus outlining risks, and don't rule out derivative products. Would you consider them a "safe" form of fixed income? Or should one only consider GIC's, savings accounts, and cash under the mattress?


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## humble_pie (Jun 7, 2009)

GoldStone said:


> Vanguard investors collectively own Vanguard. It's effectively a non-profit. Growing asset base leads to higher economies of scale. Economies of scale drive down the fees. Lower fees attract more assets. Rinse and repeat.
> 
> Passive asset management is a beautiful business. It has a tremendeous operating leverage. A company that passively manages $10B can easily manage $100B. That's a ten-fold increase in fee revenue, assuming unchanged expense ratio. The cost of revenue goes up as well, but at a much, much slower pace.



this is corporate adspeak. Increasing revenues by increasing AUM while holding costs stable is the mantra of every ETF vendor in the business. It's nothing special to vanguard.

in fact increasing revenues while holding down costs is the formula that has driven every business enterprise since the industrial revolution.

the way i see it, external costs such as custodianship will rise for any global diversified $100 billion fund. If such fund is truly holding hundreds of common stocks in outright ownership, it cannot casually dump them at the brokers. Such fund is acting as trustee for unitholders, so it requires high-quality professional custodial services. 

alas, these are expensive. 

the real-life costs of re-balancing hundreds of stocks, many of them illiquid, some in badly-regulated or corrupt 3rd world markets, will also be expensive.

my contention is that it's not possible to carry out these costly duties & still offer MERs like .05% on 240 stocks or .15% on 960 stocks in emerging markets. Something has to give, some corners have to be cut. Sampling modalities & the holding of index proxies in lieu of actual stocks are excellent strategies for cutting corners.


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## andrewf (Mar 1, 2010)

They increase AUM to lower prices. They are literally owned by their own funds, so the operate as more or less a mutual/coop. Any profits they make go back to the people who invest in their (US) funds.


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## andrewf (Mar 1, 2010)

It's also worth noting that securities lending is offsetting some of the costs for things like custodians. There is some speculation that we may see some zero or even negative MER funds because of securities lending.


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## larry81 (Nov 22, 2010)

andrewf said:


> It's also worth noting that securities lending is offsetting some of the costs for things like custodians. There is some speculation that we may see some zero or even negative MER funds because of securities lending.


Negative MER funds are coming, give a year or two


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## humble_pie (Jun 7, 2009)

oh, the horror. The only way they can lend securities is to leave the securities, on margin, at the brokers.

whatever happened to proper 3rd party professional custody? it's impossible to have both.

either a fund manager does hold securities in outright ownership, as trustee, for the benefit of innocent clients, in the most pristine professional hands that can be hired. Especially in questionable or possibly-tainted markets such as morocco, colombia, russia & vancouver.

or else the fund manager dumps securities at the local broker down in the casbah & prays that the deck of cards doesn't collapse madoff-style ...


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## andrewf (Mar 1, 2010)

Yeesh... Either they're saints or demons, eh?


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## GoldStone (Mar 6, 2011)

humble_pie said:


> the way i see it, external costs such as custodianship will rise for any global diversified $100 billion fund. If such fund is truly holding hundreds of common stocks in outright ownership, it cannot casually dump them at the brokers. Such fund is acting as trustee for unitholders, so it requires high-quality professional custodial services.
> 
> alas, these are expensive.


"Expensive" isn't going to cut it. You have to examine the numbers to make a credible argument. Let's look at the actual numbers in the audited annual report.

Vanguard International Stock Index Funds Annual Report October 31, 2013

Emerging Markets Report starts on Page 57.

Jump to Statement of Operations on Page 69. 

The fund spent *$40,325,000* on Custodian Fees.

Jump to Statement of Changes in Net Assets on Page 70.

Net Assets Beginning of 2013: $71,288,401,000
Net Assets End of 2013: $67,500,679,000

Simple average of Net Assets in 2013: $69,394,540,000

Custodian Fees as a Percentage of Net Assets: $40,325,000 / $69,394,540,000 = *0.058%*. 

0.058% custodian fee is well below the quoted management fee of the fund. This is as expected. There is nothing nefarious going on here.




humble_pie said:


> the real-life costs of re-balancing hundreds of stocks, many of them illiquid, some in badly-regulated or corrupt 3rd world markets, will also be expensive.


Vanguard index funds and ETFs use market-cap weighting. Market-cap weighted funds do not require rebalancing. They buy stocks once and they hold them forever.




humble_pie said:


> my contention is that it's not possible to carry out these costly duties & still offer MERs like .05% on 240 stocks or .15% on 960 stocks in emerging markets.


You repeated your contention many times, in this and other threads. So far, you provided no evidence to support it. None. Why? Because you can't. Your contention doesn't have any basis in reality. It's a product of your imagination. You keep saying _"oh it's expensive"_ but you never bother to check the numbers in the audited report.

HP, if this was a private conversation between you and me, I would simply shrug my shoulders and walk away. If you want to believe in conspiracy theories, so be it.

But this is not a private conversation. This is a public forum. Novice investors come here to seek advice. Many of them are stuck in awful retail mutual funds. Broad market ETFs is the best alternative for them. Some of those novice investors are afraid to make the jump to the scary new world of DIY investing. Your unsubstantiated contentions are not helping. You are spreading Fear, Uncertainty and Doubt about ETFs. I can't help but wonder about your motivation.

Please check your facts before you post "contentions".


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## leoc2 (Dec 28, 2010)

GoldStone said:


> "Expensive" isn't going to cut it. ...[/U] You are spreading Fear, Uncertainty and Doubt about ETFs. I can't help but wonder about your motivation.
> 
> Please check your facts before you post "contentions".


Perhaps he "works for", "works with", or "represents" financial planners.


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## humble_pie (Jun 7, 2009)

leoc2 said:


> Perhaps he "works for", "works with", or "represents" financial planners.



leo this attack is shameful on your part. I am the person who went to considerable trouble to personally assist you with your first planned currency gambit trades. At BMO Investorline. Approximately 3 years ago. You asked for me by name & you begged for help. I spent close to an hour answering your questions.

i don't know whether you ever went ahead & carried out the gambit transactions. But for you to repay the kindness i offered you with these ugly accusations is disgraceful.

as it happens, i've never worked in the financial industry in my life, other than a 3-month stint as a journalist undergraduate intern on the CBOE in chicago.

unlike the ETF industry shills in this forum, i post here out of a love of journalism, a love of investigation & a love of truth. I'm especially known in these parts for expertise in revealing & sidestepping brokers hidden FX fees. That is why you asked for my help in the first place.


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## Ihatetaxes (May 5, 2010)

GoldStone said:


> "Expensive" isn't going to cut it. You have to examine the numbers to make a credible argument. Let's look at the actual numbers in the audited annual report.
> 
> Vanguard International Stock Index Funds Annual Report October 31, 2013
> 
> ...


^^^ Good info.


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## humble_pie (Jun 7, 2009)

GoldStone said:


> ... I can't help but wonder about your motivation



yours is the motivation that should be wondered about imho. Ever since you arrived here you have shown so one-sided a bias in favour of ETF investing, along with so much crushing contempt for individual stock purchasers, that you have always come across as an ETF industry salesman.

it appears to me that you are still heavily selling the ETF industry. Whether through rageaholic outbursts or through sly character assassination as in the above post, your goal appears to be the smothering of all legitimate concerns & criticisms.

please don't even think to post to me about helping novice investors. I've done more to help novice investors in this forum that you will ever be able to imagine in your lifetime.

i don't work in the financial industry. I have nothing to sell. I'm not shilling for anybody.

all i have are a journo's respect for investigation & for truth. I do have a bit of financial knowledge as well, which i'm happy to try to share with others.

i've already discussed the custodial fees of $40 million earlier in this thread. Almost 2 weeks ago. Wondering why you are bringing it up again, particularly in such a patronizing heavyhanded manner? my question at the time was that $40,325,000 is too low an amount for an emerging market fund, given that such markets are notoriously lax, dysfunctional, chaotic or even corrupt. 

i don't mean to dwell on one Vanguard fund, which belongs to a family that has always enjoyed a sterling reputation. I've also mentioned XIC. There are many other funds whose announced MERs are plummeting even as we post. Since zero MERs are what consumers are demanding, one can predict that more funds are going to follow the downward competitive race.

in my view, investors should be concerned with how these cost savings are being achieved. What costs have been cut, that a business can afford to give its services away almost for free? More chillingly, how is the business secretly making money from its inventories of assets, for example by lending out securities, in order to attract & keep customers with ultra-low fees?

just upthread, your fellow ETF accolytes are talking about securities lending by ETF funds as a way to recover costs & even earn money. Coming soon, say your fellow ETF supporters, are negative MERs, apparently as a result of all the revenues that will be derived from lending out the very stocks that are supposed to belong in clear title to the ultimate beneficial owners, who are the retail investors.

securities lending? the securities are not being held in professional custody after all, but are, in fact, being held at brokers? perhaps i'm old-fashioned but is this not jarring news? should retail investors not be concerned by this?

for the sake of all retail investors everywhere, both new investors & highly experienced as you mention, i for one believe that the twin topics of plunging ETF MERs plus how these cost savings are being achieved should be discussed on forums like cmf. Should be elaborately discussed. Should be frequently discussed. Should be painstakingly discussed.


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## HaroldCrump (Jun 10, 2009)

The securities lending is a very serious concern.
Esp. for securities held by Canadians in their RRSP accounts.
Securities inside RRSP accounts - unlike taxable margin accounts - cannot be levered against by the brokerage (or its investment banking arm).
But investor or the holding brokerage has no way of preventing (or even knowing) the third-party lending by the ETF manager.

The issue with the lending is the same one as total return swap ETNs - if (or when), a large counterparty goes bust, how will the original investor be made whole again.
We know from the precious metals lending industry that there are layers upon layers of leasing & lending among the institutions.
To a point where it is difficult to keep track of who owns which stock, and who owes who what.

If the overnight commercial paper market freezes up, these brokerages and their investment banking arms will not be able to buy back the securities for those customers that may want to sell their positions.
The cascading effect of a securitized wealth management product issued by a shadow bank in China can cause a ETF provider in the US to lose its leased shares.

It is all great that over the years, retail investors have come to understand the impact of high MER fees of mutual funds, and are looking for better options.
But we have to wonder how many truly understand the nature of these ultra low cost ETFs they are buying as replacement for those traditional mutual funds.

IMHO, dismissing these concerns as irrelevant or fear-mongering is not right.


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## cainvest (May 1, 2013)

HaroldCrump said:


> But we have to wonder how many truly understand the nature of these ultra low cost ETFs they are buying as replacement for those traditional mutual funds.
> 
> IMHO, dismissing these concerns as irrelevant or fear-mongering is not right.


I would agree that dismissing concerns is not good, however, those concerns should be backed up facts and not guess work. If the financial statements of said funds show they are not using (or in a very limited amount) derivatives isn't that the end of the story?

Also, please correct me if I'm wrong here ... could not mutual funds do exactly the same thing (use derivatives) to increase their profit? So if this is the case, ALL ETFs and Mutual Funds need to be checked for derivative use.


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## humble_pie (Jun 7, 2009)

andrewf said:


> It's also worth noting that securities lending is offsetting some of the costs for things like custodians. There is some speculation that we may see some zero or even negative MER funds because of securities lending



please tell us which ETF fundcos are said to be lending securities

thank you


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## humble_pie (Jun 7, 2009)

andrewf said:


> It's also worth noting that securities lending is offsetting some of the costs for things like custodians. There is some speculation that we may see some zero or even negative MER funds because of securities lending.





larry81 said:


> Negative MER funds are coming, give a year or two



larry please tell us which ETF fundcos will be offering negative MER funds. Please also let us how they will be able to accomplish this.

thankx very much.


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## larry81 (Nov 22, 2010)

humble_pie said:


> larry please tell us which ETF fundcos will be offering negative MER funds. Please also let us how they will be able to accomplish this.
> 
> thankx very much.


No idea, its just a wild prediction.

I blindly assume security lending and minimalist governance in a plain boring SP500 ETF could result in a -0.01% MER


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## HaroldCrump (Jun 10, 2009)

humble_pie said:


> please tell us which ETF fundcos are said to be lending securities
> thank you


Hi humble,
This practice is widespread...almost rampant, one could say.
The largest asset manager in the world by AUM - BlackRock - has been accused of not only securities lending, but of not passing on the proceeds to the investors.
There was a lawsuit against them, which was dismissed last year:

_*Court Dismisses Securities Lending Suit Against BlackRock*_

Other well known suspects are Guggenheim Funds, iShares (now BlackRock, of course), State Street Funds, and the great & venerable Vanguard Corporation.
In other words, pretty much all the major ETF managers indulge in this practice.

However, one key differentiator is that Vanguard returns the full 100% of the proceeds from securities lending back to the fund, vis-à-vis other providers that return between 20% to 40% of the proceeds only (that is what the BlackRock lawsuit was about).

Another tidbit is that it appears that funds/ETFs may be biasing their security selection based on the leasing premium of one security vs. another.
As a result of this, funds that favor one security over another based on its rental potential tend to underperform the fund category.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2101604


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## GoldStone (Mar 6, 2011)

humble_pie said:


> just upthread, your fellow ETF accolytes are talking about securities lending by ETF funds as a way to recover costs & even earn money. Coming soon, say your fellow ETF supporters, are negative MERs, apparently as a result of all the revenues that will be derived from lending out the very stocks that are supposed to belong in clear title to the ultimate beneficial owners, who are the retail investors.
> 
> securities lending? the securities are not being held in professional custody after all, but are, in fact, being held at brokers? perhaps i'm old-fashioned but is this not jarring news? should retail investors not be concerned by this?


No, this is not jarring news. Institutional security lending doesn't work the same way as retail security lending.

Retail brokers can lend securities held in the margin accounts without asking the account holders for consent. Institutional lending doesn't work like that.

Blackrock, Vanguard et al have dedicated security lending departments. Lending departments decide which securities to lend, to whom, and under which conditions. They lend securities to other institutional investors, typically hedge funds. The other party has to post a liquid collateral. The value of the collateral has to exceed the value of the loaned securities. Once the loan transaction is arranged, the lender instructs the custodian bank to transfer the loaned securities.

Blackrock primer on securities lending

Securities lending: What makes Vanguard different?

International Securities Lending Association: An Introductory Guide To Securities Lending

----

On the subject of negative MERs... they are already here.

How Short Sellers Boost Your ETF Returns











-- just the facts


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## GoldStone (Mar 6, 2011)

Vanguard paper on the risks of securities lending and what Vanguard does to minimize them.

Securities lending: Still no free lunch



> Executive summary.
> 
> Securities lending continues to be much in the news. The practice refers to the temporary transfer (“lending”) of a security by one party to another in exchange for cash collateral that can in turn be reinvested to produce income for the lender. Thus, securities lending can be an attractive source of revenue. Because securities lending is a rather straightforward process, many investors have perceived it as a relatively risk-free way to increase the return on an equity or bond portfolio. However, there are pitfalls. This paper examines these risks, which were highlighted during the late-2000s credit crisis, and also compares the two approaches to securities lending. In one approach, volume-oriented strategies lend out a large percentage of easy-to-find securities and then attempt to boost revenues by reinvesting the cash collateral in more aggressive investment pools. Conversely, the strategy that Vanguard believes is more prudent and more likely to provide a superior risk–reward trade-off is known as value lending. This strategy involves lending only those securities that generate significant revenue and minimizing the risk by investing the collateral in low-risk money market securities.


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## GoldStone (Mar 6, 2011)

HaroldCrump said:


> Other well known suspects are Guggenheim Funds, iShares (now BlackRock, of course), State Street Funds, and the great & venerable Vanguard Corporation.
> In other words, pretty much all the major ETF managers indulge in this practice.


_"suspects"_ and _"indulge"_ is unnecessary inflammatory language. You make it sound like they do something secret or illegal.

All ETF providers disclose the practice. All you have to do is read the fund prospectus before you invest. Securities lending revenue is a line item in the annual fund reports.


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## andrewf (Mar 1, 2010)

humble_pie said:


> please tell us which ETF fundcos are said to be lending securities
> 
> thank you


Tell me one that isn't.

https://advisors.vanguard.com/VGApp...ommentary/article/IWE_InvResSecuritiesLending

"Securities lending is a common practice among mutual funds, ETFs, pension funds, and insurance companies, which lend securities from their portfolios to broker-dealers, hedge funds, and investment banks in return for a fee. Collateral, generally in the form of cash and/or government securities, is delivered by the borrower in an amount greater than the loaned securities' value. In addition to the fee that a lender can generate from lending a security, the lender also earns interest by reinvesting the posted cash collateral."


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## HaroldCrump (Jun 10, 2009)

GoldStone said:


> _"suspects"_ and _"indulge"_ is unnecessary inflammatory language. You make it sound like they do something secret or illegal.
> All ETF providers disclose the practice. All you have to do is read the fund prospectus before you invest. Securities lending revenue is a line item in the annual fund reports.


Declaring the revenue generated from securities lending does not end all disclosure responsibilities.
The issue is the transparency, regulation, and investor protection (rather, lack of all 3).

There is currently no standards or regulation around the following:
- What % of portfolio is allowed to be leased
- What % of lending income should be flowed back to the fund, and what % is the fund management allowed to appropriate
- What is acceptable collateral (such as those wonderful AAA-rated asset backed bonds - we all know how liquid and 5* they turned out to be).
- What are acceptable instruments for cash collateral re-investment (again, those wonderful AAA rated bonds)
- No requirement to purchase mandatory CDS protection for each borrower
- No restrictions or regulation of re-leasing (and re-re-re-leasing)

The entire practice is opaque and over-the-counter.

The low MERs and the additional yield is all great.
But all it takes is one large counter-party to fail, and the respective govt. refusing to bail them out, for this party to end.
In this day & age, no govt. has the appetite to bail out non deposit assets of any major bank, insurance company, financial institution, let alone hedge funds.

In some ways, a pure total return swap based ETN is safer & simpler than a complex web on securities lending based ETF.
In the former case, the counterparty risk can be managed with a single CDS.
As long as the swap is in turn not leased out, it should be okay.


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## humble_pie (Jun 7, 2009)

GoldStone said:


> Blackrock, Vanguard et al have dedicated security lending departments. Lending departments decide which securities to lend, to whom, and under which conditions. They lend securities to other institutional investors, typically hedge funds. The other party has to post a liquid collateral. The value of the collateral has to exceed the value of the loaned securities. Once the loan transaction is arranged, the lender instructs the custodian bank to transfer the loaned securities ... just the facts




please correct me if i'm wrong. You're saying that millions of canadians are holding millions of dollars' worth of ETFs in their retirement accounts - possibly trilliions of dollars' worth of ETFs in their retirement accounts - but these funds are *not* holding the squeaky-clean-all-america-apple-pie common stocks that they claim they are holding in their popular literature?

you're saying this is because the ETFs have loaned out the stocks to unknown hedge funds located in god knows what country?

you're saying the ETFs hold almost nothing but collateralized swap promissory notes to return the securities some day?

my, my. Somebody better explain this very clearly to the canadian minister of finance.


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## cainvest (May 1, 2013)

So what message, according to some posters, am I reading here? Is it that Mutual funds and ETFs are very high risk investments (much higher risk that owning stocks directly) due to derivatives and such plus their fund prospectus can't be trusted?


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## GoldStone (Mar 6, 2011)

cainvest said:


> So what message, according to some posters, am I reading here? Is it that Mutual funds and ETFs are very high risk investments (much higher risk that owning stocks directly) due to derivatives and such plus their fund prospectus can't be trusted?


cainvest,

The claims about derivatives are blown out of proportions by a single poster. Said poster has a long track record of vicious attacks on passive investing and passive investors. Her knowledge of the indexing products is rather sketchy (she doesn't use them herself). Her posts in this thread are filled with glaring mistakes.

But don't take my word for it.

I strongly recommend that you form your own judgement. Read the prospectuses. Read the annual reports. Read the white papers. Anonymous internet forum is not a substitute for your own due diligence.

Start a new thread if you have technical questions about ETFs. Many CMF members have a good understanding of the ETF mechanics. I am sure that someone will be happy to explain.


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## GoldStone (Mar 6, 2011)

Harold, you raised some good points in post #67. I will reply later when I have more time. I want to do your post justice and comment properly.


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## humble_pie (Jun 7, 2009)

GoldStone said:


> cainvest,
> 
> The claims about derivatives are blown out of proportions by a single poster. Said poster has a long track record of vicious attacks on passive investing and passive investors. Her knowledge of the indexing products is rather sketchy (she doesn't use them herself). Her posts in this thread are filled with glaring mistakes.
> 
> ...



poor goldstone the ETF shill is scared

vicious? look at gold's message history if u want to see a truly ugly verbal abuser

there is not one "single" poster looking with deep concern at the large, complex, breaking story about the flimsy underpinnings of some ETF structures. There are at least two, both writing penetrating posts about issues that absolutely should be raised, for the sake of investors everywhere.

both posters are senior members with matchless reputations as investigators & as writers. Reputations that go back long before goldstone ever joined & promptly showed himself to be the ETF shill that he is. 

deal with it, goldstone. There are serious questions that should be raised about the ETF industry. That will be raised about the ETF industry. All that you have accomplished so far, with your vile personal attacks, is to bring dishonour & disrepute to the very firm you work for.

here, for example, is a serious & legitimate question:

if so many securities are loaned out to hedge funds, then how can an ETF have significant custodial fees? one would assume that custody is not needed for collateral received, nor for securities loan agreements.


----------



## andrewf (Mar 1, 2010)

Uh oh, the humble pie is praising itself in the third person again. Somebody get the spray bottle!


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## humble_pie (Jun 7, 2009)

another ETF shill :biggrin:


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## andrewf (Mar 1, 2010)

And HP, rather than cast aspersions on ETF providers in the absence of information (you are just speculating about the evil these nefarious firms are up to), why not pose your questions to the customer relations teams at one or more (perhaps start with Vanguard, as they seem to have attracted the lion's share of your ire) and then post their responses here, perhaps with your own take on what they mean. What you are doing now is little more than stirring up FUD. Why not ask these questions about insurance companies, too? Those sly devils are investing in OTC derivatives with millions of individuals' annuities and life insurance monies. They could wipe out the retirement income of millions tomorrow, or perhaps next Tuesday! The story is just breaking about how insurance companies are just heartbeats away from destroying the financial health of millions of individuals....


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## humble_pie (Jun 7, 2009)

i'm not casting aspersions in the least. What haroldCrump & i have raised are serious, penetrating questions that deserve to be seriously answered, so as to clarify matters for all canadian ETF investors.

eventually, of course, these questions *will* be answered. It's not my goal to get them answered myself. It's only my goal to expose the weakness & the poor communications that the ETF industry is presently offering to its clients.

there is a movement at present, throughout the securities industry, to force greater product transparency for financial consumers. It has produced a new set of CMR regulations, for example.

the shift means clear, simple language upfront in documents for financial consumers. For example, it would mean no more fleeting references to securities lending buried deep in one-line financial statements, or buried in a brief sentence under Risk Factors in ETF prospectuses. It would mean telling consumers, clearly & up front, that many or even most of *their* securities are not being held by Fundco but have, in fact, been loaned out.

as for the ETF call centres, i did a spot check on the leading ones well over a year ago. I was appalled by the results. There was so much ignorance. It reminded me of the broker coverups to the FX fees that were being charged on USD dividends, including double FX fees in some RRSPs, where the licensed representatives would make up any old fairytale to fend off customers who might inquire.

in my impromptu survey, i found that the only ETF house that was capable of accurately discussing what it actually held in a particular fund vs what the fund was mimicking but not holding, was horizons betaPro. I was impressed by the firm. But i've already written about that.


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## GoldStone (Mar 6, 2011)

hp, 

Show some humility at last. Your knowledge of ETFs is shaky at best. You made a number of glaring mistakes in this thread. I refuted them one by one armed with numbers and references. It's high time you acknowledge this.

You didn't know that index sampling does not equate derivatives. That's Indexing 101.

You grossly exaggerated the cost of custodian fees. The numbers are readily available in the annual reports. But you didn't stop there. You jumped to conclusion that ETFs must be using derivatives because custodian fees are so prohibitively expensive.

You didn't know that ETFs engage in securities lending until someone casually mentioned it in this thread. If not that casual reference, you would still be in the dark.

"Senior member", huh.

Do you know that securities lending predates ETFs? Asset managers loaned securities to short sellers for ages, long before ETFs got invented.

Do you know that Canadian public pensions engage in securities lending to enhance plan returns? Caisee does it. OMERS does it. BC Public Sector Plan does it. Alberta Public Sector Plan does it too. Are you going to report them all to the Ministry of Finance? That idea of yours is hysterical.

hp, your debating style is "throw some mud at the wall and hope it sticks". You don't fact check. You don't quote the prospectuses. You don't reference fund reports. You never cite any numbers. You just keep throwing mud at the wall. And when it falls down, you throw some more.


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## GoldStone (Mar 6, 2011)

oh, I forgot another glaring mistake.

When you learned about security lending by ETFs, you jumped to conclusion that ETFs must be holding their securities in the brokerage accounts. That idea is hysterical too. Just shows how little you know about the subject.


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## humble_pie (Jun 7, 2009)

GoldStone said:


> hp ...



what concerns me in this thread is that HC & i have raised specific, legitimate, thoughtful questions about troubling or clouded aspects of the ETF industry, but nearly all of the "answers" have been nothing more than scorn, personal insults & ugly ad hominem attacks.

the above is another example. It has nothing to do with the issues we have raised. It is just another spewing out of sick hatred.

HC has repeatedly raised the risk of counterparty failure in ETF dealings. I share this concern.


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## humble_pie (Jun 7, 2009)

GoldStone said:


> oh, I forgot another glaring mistake.
> 
> When you learned about security lending by ETFs, you jumped to conclusion that ETFs must be holding their securities in the brokerage accounts. That idea is hysterical too. Just shows how little you know about the subject.



if you believe otherwise, why don't you calmly furnish the information?

the hysterical person is yourself


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## GoldStone (Mar 6, 2011)

humble_pie said:


> HC has repeatedly raised the risk of counterparty failure in ETF dealings. I share this concern.


I posted a link to Vanguard paper that addresses your concern. Did you read it?



humble_pie said:


> if you believe otherwise, why don't you calmly furnish the information?


I already did. You ignored it.


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## HaroldCrump (Jun 10, 2009)

andrewf said:


> Why not ask these questions about insurance companies, too? Those sly devils are investing in OTC derivatives with millions of individuals' annuities and life insurance monies. They could wipe out the retirement income of millions tomorrow, or perhaps next Tuesday!





GoldStone said:


> Do you know that Canadian public pensions engage in securities lending to enhance plan returns? Caisee does it. OMERS does it. BC Public Sector Plan does it. Alberta Public Sector Plan does it too. Are you going to report them all to the Ministry of Finance?


Both of these are technically correct.
Yes, insurance companies loan out securities, too.
Yes, security leasing pre-dates mainstream ETFs, and pension funds, etc. do it too.

But there are a couple of key differences in those cases.

All the pension funds mentioned above are back-stopped & fully guaranteed by various provincial pension guarantee agencies, which are crown corps.
Further, they are all implicitly backed by the Federal govt. of Canada.
The Federal govt. of Canada will do whatever it takes to back-stop and bail out OMERS and caisse de depot.
They will pillage tax-payers savings accounts, if needed, to bail out these major pension funds.

As for insurance companies, they are protected by Assuris, or whatever the insurance guarantee agency is called.

But none of these conditions apply to private ETF providers such as iShares (now BlackRock), PWL, Horizons, etc.
No one is gonna bail them out.

There is literally zero appetite at any govt. level to bail out these types of institutions again.

As a result of lobbying by the mutual fund and ETF industry, there were several key changes made to the regulations governing mutual funds and ETFs between 2010 and 2012 by the CSA and OSFI.
The rules around short selling of securities by Canadian mutual were relaxed.
Several new exceptions were created.
The type of securities acceptable as collateral was also changed.
Commercial paper and money market paper is now acceptable as collateral.
There seems to be no rules governing the re-investment of cash collateral.

I keep saying - all this is great as long as everything is going fine.
But it takes only one major counter-party failure for this whole circus to unravel.

No one will come to the rescue of investors holding these synthetic ETFs that lease out the majority of its holding.
The counter-party will be allowed to fail by the respective govt.
The collateral will be frozen for days, if not weeks.
By the time the collateral is un-frozen, the underlying securities would have corrected by 25% to 40% perhaps.

Risk is not merely the probability that something will happen - it is the probability multiplied by the impact if -ve scenario comes to pass.
Low probability but high impact still leads to high risk.


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## GoldStone (Mar 6, 2011)

humble_pie said:


> what concerns me in this thread is that HC & i have raised specific, legitimate, thoughtful questions about troubling or clouded aspects of the ETF industry, but nearly all of the "answers" have been nothing more than scorn, personal insults & ugly ad hominem attacks.


"troubling or clouded aspects" is yet another example of you throwing mud. I posted a factual answer to every single contention of yours. You ignored them all. You are not interested in factual answers. You move right past them. Your questions are just a tool to cast aspersions and spread FUD.

I am out of this thread. It's poisoned beyond repair.


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## GoldStone (Mar 6, 2011)

Harold, can you please address this. It's from Vanguard paper.

----

*Conservative collateral management*

Vanguard reinvests the cash collateral in an ultraconservative money market fund managed by Vanguard Fixed Income Group. The fund focuses on principal preservation by holding investments such as repurchase agreements, short-maturity government securities, and bank certificates of deposit with an average maturity capped at 60 days.

Furthermore, Vanguard marks to market each securities-lending transaction on a daily basis to ensure proper collateral coverage in case of borrower default. We require cash collateral of at least 102% for all U.S. equity loans and at least 105% for all non-U.S. equity loans. Vanguard monitors collateralization across each securities loan transaction, counterparty, and fund, among other collateralization checks.

*Stringent screening of borrowers*

To mitigate counterparty default risk, Vanguard lends securities solely to a limited number of pre-approved broker-dealers and adheres to strict, self-imposed guidelines on the aggregate dollar amount of loans made to each approved borrower. Vanguard Fixed Income Group rigorously analyzes all prospective borrowers to ensure that they meet high standards for credit quality. Continuous analysis and ongoing surveillance of each borrower result in changes to borrower guidelines when appropriate.

----

Suppose the counterparty fails. Vanguard owns the money market collateral. They can use it to re-buy the loaned securities. If counterparty fails due to a systemic crisis, chances are that loaned securities trade at a deep discount to the borrowed value. If they are not trading at a discount, the worse that can happen is that ETF will suffer a large tracking error in that particular year.


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## humble_pie (Jun 7, 2009)

GoldStone said:


> ... Suppose the counterparty fails. Vanguard owns the money market collateral. They can use it to re-buy the loaned securities.


no, not at all. They cannot count on using the collateral unless it was marked-to-market. I've been looking for this mark-to-market provision & have observed that it is never present.

in a scenario where a counterparty fails for unique reasons of its own (think Long Term Capital) *but* the overall market has soared, the original collateral will be insufficient to buy more than a portion of what is owing to the fund unitholders.

i've left out the rest of this long & somewhat pompous quote because it was obviously written in adspeak. Stringent. Pre-approved. Strict, self-imposed guidelines. Puff. Puff.


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## GoldStone (Mar 6, 2011)

humble_pie said:


> They cannot count on using the collateral unless it was marked-to-market. I've been looking for this mark-to-market provision & have observed that it is never present.


Re-read post #84

"Furthermore, Vanguard marks to market each securities-lending transaction on a daily basis to ensure proper collateral coverage in case of borrower default."


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## GoldStone (Mar 6, 2011)

humble_pie said:


> in a scenario where a counterparty fails for unique reasons of its own (think Long Term Capital) *but* the overall market has soared, the original collateral will be insufficient to buy more than a portion of what is owing to the fund unitholders.


They have a full time securities lending department. They monitor the value of loaned securities. If the market is going up, they can either call back the securities or demand more collateral.


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## humble_pie (Jun 7, 2009)

GoldStone said:


> Furthermore, Vanguard marks to market each securities-lending transaction on a daily basis to ensure proper collateral coverage in case of borrower default. We require cash collateral of at least 102% for all U.S. equity loans and at least 105% for all non-U.S. equity loans.
> 
> Suppose the counterparty fails. Vanguard owns the money market collateral. They can use it to re-buy the loaned securities. If counterparty fails due to a systemic crisis, chances are that loaned securities trade at a deep discount to the borrowed value. If they are not trading at a discount, the worse that can happen is that ETF will suffer a large tracking error in that particular year.



but who is paying for the marking to market? that's what i meant. If securities rise substantially in value, is vanguard paying for the daily mark to market? that could become very expensive, would create a huge drag on cash.

if there is an alternate arrangement for the borrower to keep on paying the mark, i cannot see any sign of that.


Edit: i suppose requiring cash collateral of 102% would amount to a de facto marking to market which the counterparty is supposed to pay. If securities soared, the counterparty would have to increase its collateral, possibly even on a daily basis.

but the case i am concerned with is the counterparty that is failing. It may have produced 102% originally, but now it can offer nothing. Any ETF in this position, whether vanguard or not, is then on the hook for the full value of the securities. 

the situation reminds me of being short a naked call. It is really very dangerous imho.EE


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## GoldStone (Mar 6, 2011)

Vanguard Emerging Markets annual report, again.

http://www.vanguard.com/funds/reports/q720.pdf

Page 69. 

Securities Lending Income: 40.2M or about 0.058% of the 70B fund.

The borrow rates on the hard-to-borrow illiquid EM securities can reach 100% or more. The fact that they only earned 0.058% is a sign that their lending program is quite conservative.

(Incidentally, their securities lending income is almost exactly the same as their custodian fee expenses. The two offset each other. This is just a passing observation.)


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## cainvest (May 1, 2013)

GoldStone said:


> cainvest,
> 
> The claims about derivatives are blown out of proportions by a single poster. Said poster has a long track record of vicious attacks on passive investing and passive investors. Her knowledge of the indexing products is rather sketchy (she doesn't use them herself). Her posts in this thread are filled with glaring mistakes.
> 
> ...


I understand your position GoldStone, and thanks for the information .... what I'd like to hear is humble_pie's response.

Also, another question for humble_pie ... so with the information you have what should the average investor do in your opinion? Should they avoid all ETFs (and I guess Mutual funds as well) for the time being until the information you are seeking becomes available?


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## GoldStone (Mar 6, 2011)

humble_pie said:


> if there is an alternate arrangement for the borrower to keep on paying the mark, i cannot see any sign of that.


That arrangement would be spelled in the loan contract between Vanguard and the counterparty. There is no way for us to see it.

Common sense suggests they can either make the margin call, or demand more collateral.


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## humble_pie (Jun 7, 2009)

GoldStone said:


> That arrangement would be spelled in the loan contract between Vanguard and the counterparty. There is no way for us to see it.
> 
> Common sense suggests they can either make the margin call, or demand more collateral.



here we are getting into the very area of most critical concern. I posted about this below, but in summary, to demand more collateral from the counterparty is tantamount to having the counterparty be responsible for the mark to market.

however - & this is the most crucial part of all - in a failing counterparty scenario, they cannot pay anything. This would leave the ETF provider on the hook for the securities.

again we come down to the problems of *where* those securities are actually being held in custody. Does the counterparty hold them? (would turn out badly if they are failing) are securities held by 3rd party professional custodial service? (could turn out better)

in any event, a failed counterparty that cannot keep its collateral up to snuff would leave the ETF provider in a position similar to the seller of a naked call. It's the most dangerous option position of all.


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## GoldStone (Mar 6, 2011)

humble_pie said:


> however - & this is the most crucial part of all - in a failing counterparty scenario, they cannot pay anything. This would leave the ETF provider on the hook for the securities.


From:
https://personal.vanguard.com/pdf/icrsl.pdf

Page 4:

"To reduce the risk of counterparty default, Vanguard lends securities to a limited number of preapproved broker-dealers and maintains strict internal guidelines on the aggregate dollar amount of loans to any one approved borrower. In addition, Vanguard ensures proper collateral coverage by valuing the loaned securities on a daily basis—using current market prices—and by calling for additional collateral when necessary to bring the coverage levels up to the 102% or 105% floor levels for U.S. or foreign securities, respectively. *Vanguard’s agency agreement requires the lending agent to indemnify our fund in the case of a counterparty default by replacing either the security or the security’s current market value to the fund.*"

----

Page 6 clarifies what they mean by "the lending agent". It's a broker-dealer or a custodian bank that intermediates the transaction between Vanguard and the counterparty.


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## HaroldCrump (Jun 10, 2009)

GoldStone said:


> Vanguard reinvests the cash collateral in an ultraconservative money market fund managed by Vanguard Fixed Income Group. The fund focuses on principal preservation by holding investments such as repurchase agreements, short-maturity government securities, and bank certificates of deposit with an average maturity capped at 60 days.


Right, but those are precisely the type of securities that freeze up during a credit crisis.

The money markets are full of all kinds of commercial paper, bankers' acceptances (BA), and of course the repos.
Many money market funds had to suspend redemptions in late 2008/early 2009.

The repo market is not without its share of toxic securities fraud.

Do you recall the conviction of Lee Farkas of Taylor Bean in the aftermath of the credit crisis?
_*He described in detail how the repos are used to advance worthless collateral in the money market*_.

Lehman was able to borrow in the overnight market right up until the week before they went under.
At that time, they were leveraged 70:1.
Yet, they were able to borrow against collateral.

It was only during that fateful weekend when the Barclays takeover talks fell through that all major lending institutions refused to lend them any more starting Monday.

Any collateral, except US treasuries and cash, carry risk.
The key fact is that _the conditions that would cause a large counter-party to fail would be precisely the same conditions that'd cause the money markets to freeze up_.
These two events will occur in parallel, or soon after one another.

The exogenous event could be the failure of a shadow bank in China or Japan, who knows.

It is not that the underlying repo agreement or commercial paper is bad - no, it could be quite good in normal times.
However, during a credit crisis, no one wants to lend to each other.

Mark-to-market does not work under those circumstances - there is no market at that point.
There are zero bids for those securities.

Anyhow, my point is that securities lending is exposing the investor to a risk that he/she has not signed up for.
A passive index investor in say VTI or CDZ or whatever has signed up for equity risk in those specific companies (that could range from 10 stocks to a 1,000 stocks).
But they have not signed up for a credit freeze risk. 
They have not signed up for the short term money market credit risk.

I'd bet the vast majority of investors do not even know what risks they have signed up for.

You clearly know your way around these prospectuses.
In fact you seem to know them like the back of your hand.
But how many small, passive index investors are reading and understanding these?

Where is the investor protection?

Canadian domiciled ETFs and mutual funds are covered by a plethora of agencies - from the OSC, OSFI, CSA & MFDA.
But Canadians buying US domiciled ETFs in their registered accounts are not governed by these institutions - those funds are covered by the SEC.

If retail investors were somehow made to understand the risks, what do you think the vast majority of them will prefer between the following two options:
- Pay 50 bps more in MER fees, or
- Stay exposed to counter-party risk and credit markets risk

Note again that as far as they know, they have signed up only for equity risk in those specific companies that comprise their fund.
This is esp. true of conservative investors buying funds that hold only blue-chip stocks.
A long blue chip equity investor does not expect to be automatically exposed to the risks of other asset classes and other types of markets, such as money market, OTC credit derivatives, etc.


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## GoldStone (Mar 6, 2011)

Harold, I think you grossly exaggerate the risk associated with security lending. The risk is miniscule compared to equities risk.

1. You skipped this part:

*"Vanguard’s agency agreement requires the lending agent to indemnify our fund in the case of a counterparty default by replacing either the security or the security’s current market value to the fund."*

2. Let's assume the worst case scenario: global financial crisis on the scale of 2008 or worse.

The counterparty that loaned the securities fails. The lending agent that is supposed to indemnify the fund fails.

The collateral sits in Vanguard money market fund.

Take a look at MMF holdings:
https://personal.vanguard.com/us/funds/snapshot?FundId=0030&FundIntExt=INT#tab=2

Average maturity is 58 days. All holdings are First Tier credit rating. Repurchase agreements and commercial paper amount to less than 10% of the fund holdings.

Let's assume the worst: MMF is forced to break the buck. Let's say it pays 80c-90c on the dollar.

*Where do you think loaned equities will be trading in this Armageddon scenario???*

They will be trading at a 40%-60% discount to the loaned value, just like the did in 2008. Maybe worse. You take your 80c-90c of the collateral, re-purchase the loaned securities 40c-60c on the dollar, and you pocket the difference.

Again, I think you grossly exaggerate the collateral risk. Equities risk is the big elephant in the room.


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## cainvest (May 1, 2013)

cainvest said:


> I understand your position GoldStone, and thanks for the information .... what I'd like to hear is humble_pie's response.
> 
> Also, another question for humble_pie ... so with the information you have what should the average investor do in your opinion? Should they avoid all ETFs (and I guess Mutual funds as well) for the time being until the information you are seeking becomes available?


Well I guess no response from humble_pie is a very positive thing, didn't expect one anyways. So it's business as usual since there is no "real" additional risks with ETFs or Mutual Funds that the average investor needs to worry about, well, other than standard equity exposure.


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## cainvest (May 1, 2013)

GoldStone said:


> Again, I think you grossly exaggerate the collateral risk. Equities risk is the big elephant in the room.


From what I can extract from fund documentation, derivativies and lending make up (if any at all) a very small % of the funds total value. Of course I'm only looking at the funds I own (core index stuff) so other funds maybe different. BTW, anyone else hate the sedar search tool .. wish they provided better searching options.


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## humble_pie (Jun 7, 2009)

not going to answer you ever, cainvest

sorry, i don't waste time on trolls

everything you asked has already been dealt with


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## Eclectic12 (Oct 20, 2010)

HaroldCrump said:


> ... Where is the investor protection?
> 
> Canadian domiciled ETFs and mutual funds are covered by a plethora of agencies - from the OSC, OSFI, CSA & MFDA.
> But Canadians buying US domiciled ETFs in their registered accounts are not governed by these institutions - those funds are covered by the SEC...


I'm confused by this one ... are you saying that Canada has better agencies so that the Canada domiciled ETFs that have become "index happy" are in better shape than the US domiciled ones, who have done the same?

I seem to recall XIC being listed as another ETF that has dropped it's MER as it became "index happy" and presumably, subject to the same risk.


Cheers


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## HaroldCrump (Jun 10, 2009)

cainvest said:


> From what I can extract from fund documentation, derivativies and lending make up (if any at all) a very small % of the funds total value.


You are mixing the two separate issues.

What % of fund assets can be derivatives is one issue.
I believe that limit is 10% for Canadian domiciled funds as per CSA rules.
Which means a classic equity ETF like XIU can hold 90% of its assets as direct stock holdings, and 10% as derivatives, such as call options or futures.

What % of its actual stock portfolio it is allowed to lease out (in exchange for collateral) is a different thing.
Note that the collateral it receives in exchange is not subject to that 10% derivative rule.
The leased securities are not derivatives, and neither are the collateral securities they received in lieu.

Thus far, I have not seen any rules that dictate what % of securities can be leased by Canadian domiciled funds.
Based on the links posted by GoldStone above, there doesn't seem to be any restrictions.
Conceptually, the entire portfolio can be leased out in lieu of collateral.

The quality of the collateral is a separate issue.

Anyhow, if you understand and accept the risks of security leasing and collateral (or you consider them inconsequential/trivial), that's fine.
But don't assume that only a "very small %" is being leased out.

Think about it...if a very small % of securities are leased out, how are these funds able to offer super uber ultra low MER fees?
There is even talk of -ve MERs i.e. _they _will pay _you _to buy their fund.

No, my friend, they are not leasing out a "very small" % of their fund - these guys are leasing out the _*entire *_fund.


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## HaroldCrump (Jun 10, 2009)

Eclectic12 said:


> I'm confused by this one ... are you saying that Canada has better agencies so that the Canada domiciled ETFs that have become "index happy" are in better shape than the US domiciled ones, who have done the same?
> 
> I seem to recall XIC being listed as another ETF that has dropped it's MER as it became "index happy" and presumably, subject to the same risk.


What do you mean "index happy"?
Do you mean sampling?
i.e. XIC used to own thousands of TSX stocks and now does sampling?

Sampling is a completely separate issue.
The worst that sampling can do is create a tracking error.

BTW, I didn't mean that Canada has better or worse regulatory agencies.
I meant who is protecting the Canadian investors when they buy US domiciled funds in registered accounts?
Canadian registered accounts in general are protected (from security lending by the brokerages) by Canadian regulators and the Ministry of Finance (which disallow naked options, short selling, etc. in registered accounts).
But the Canadian MoF or the OSC cannot protect a Canadian's account if they bought a US ETF that went belly up because of counter-party collapse.


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## cainvest (May 1, 2013)

humble_pie said:


> not going to answer you ever, cainvest
> 
> sorry, i don't waste time on trolls
> 
> everything you asked has already been dealt with


Already figured out you're not going to respond to my questions and I'm fine with that. 

And while I'm likely just an average DIY investor with much of these discussions going beyond my knowledge base, I do like to hear the opinions put at a higher level so I can understand the positions better. Obviously you don't see it like that and prefer not to help, hey that's your choice.

BTW, please keep you derogatory comments to yourself, as in calling me a troll, I'm just trying to understand everyones position.


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## cainvest (May 1, 2013)

HaroldCrump said:


> You are mixing the two separate issues.
> 
> What % of fund assets can be derivatives is one issue.
> I believe that limit is 10% for Canadian domiciled funds as per CSA rules.
> ...


I understand they are two different things, just stating that in my eyes they are both to be identified as "additional risks" on top of holding the equity position. Is there not any reporting on the financial sheet for the funds related to leased securities? Now I"m not sure what some of the financial sheet line items are (yes, in over my head here), like "Securities lending income" and don't even know if that relates to the lending question at hand. 

BTW, I do understand your concern that lending securities from a fund may not have any regulations but how does one determine this (not just going by low MERs) on a fund by fund basis?


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## GoldStone (Mar 6, 2011)

HaroldCrump said:


> No, my friend, they are not leasing out a "very small" % of their fund - these guys are leasing out the _*entire *_fund.


Please cite some evidence to support this statement.


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## GoldStone (Mar 6, 2011)

cainvest said:


> BTW, I do understand your concern that lending securities from a fund may not have any regulations but how does one determine this (not just going by low MERs) on a fund by fund basis?


Find "Securities Lending Income" and "Net Assets" in the annual report. Calculate lending income as a percentage of assets. Compare this number to other ETFs. This will give you an idea of how aggressive your ETF is with respect to security lending.

Canadian Couch Potato:

ETF Risks in Perspective: Securities Lending

----

You can learn the extent of an ETF’s securities lending by checking its Management Report of Fund Performance and its financial statements (look under “Statement of Operations”), both of which you can find at SEDAR. In most cases, you’ll find that the revenue is very small. For example, the iShares S&P/TSX 60 (XIU) has about $10 billion in assets and earned all of $157,000 from securities lending in the first half of 2011. The iShares DEX Universe Bond (XBB), with $1.7 billion under management, raked in a whopping $25,000 during the same period.

----


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## GoldStone (Mar 6, 2011)

Canadian mutual funds regulation governs Canadian ETFs:

National Instrument 81-102: Investment Funds

Sections 2.12 - 2.17 govern security lending.


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## humble_pie (Jun 7, 2009)

GoldStone said:


> ... For example, the iShares S&P/TSX 60 (XIU) has about $10 billion in assets and earned all of $157,000 from securities lending in the first half of 2011. The iShares DEX Universe Bond (XBB), with $1.7 billion under management, raked in a whopping $25,000 during the same period.



this is interesting, because XIU is the one of the pair of core TSX funds from black rock that did *not* lower its MER recently.

the one that did lower was XIC, a fund that is far smaller & presumably held by retail investors to a greater extent. XIU is held by many institutions, it's a hi-volume favourite for institutional options trading on the montreal exchange.

for some time now, while puzzling over this unrealistic phenomenon of giant core equity funds with MERs dropping close to zero or even lower, i have been thinking that Black Rock understood that canadian investing institutions, particularly pension funds, would not accept any high levels of securities lending. I have been thinking that that was why the XIU MER levels remained where they were (even so, the fund is an MER bargain.) Because there are significant custodial fees, along with low revenues from securities lending.

meanwhile, XIC was/is a much smaller fund with, presumably, weaker or no levels of institutional support, so it was easier for black rock to tinker with it.

next step: what are the lending statistics for XIC

this is part of the overall question: how did Black Rock manage to take the MER of this fund, which says it owns no less than 243 canadian common stocks, down to one-half of one percent? this, i believe, is a capped fund, so re-balancing would be necessary?

almost the entire tail half of this fund consists of vancouver-type small caps or penny stocks. These are notoriously difficult to trade, with big spreads between bids & asks. Sometimes these stocks even become illiquid for a while. 

translation: some corners surely had to be cut, to get that XIC MER down to one-half of one per cent. What were these corners?

once again, as i have mentioned, i do not need to supply the answers or any kind of "proof." All i need to do is ask the questions. It would be nice if there could be an ETF industry spokesperson who would be capable of responding calmly, though. Without insults, jeers, scorn, foul invective, personal attacks or character assassination.


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## GoldStone (Mar 6, 2011)

BlackRock didn't lower XIU MER for one simple reason: it's their cash cow. Taxable XIU investors are trapped by the capital gains taxes. They grind their teeth and continue to pay the higher MER.

XIC is a small fund. They lowered the MER to compete with Vanguard and BMO. The foregone revenue in XIC is trivial compared to XIU revenue.

This is a purely business decision by BlackRock. It has nothing to do with security lending.


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## GoldStone (Mar 6, 2011)

June 30, 2014

XIC - Semi Annual Management Report of Fund Performance

----

Securities Lending Agents

The Fund has engaged BlackRock Institutional Trust Company, N.A. (“BTC”) and BlackRock Advisors (UK) Limited (“BRAL”), affiliates of BlackRock Canada, as securities lending agents. To mitigate risks from securities lending, *the Fund benefits from a borrower default indemnity provided by BlackRock*, an affiliate of BlackRock Canada. *BlackRock’s indemnity allows for full replacement of securities lent*. BTC and/or BRAL bear all operational costs directly related to securities lending as well as the cost of borrower default indemnification. *For the six-month period ended June 30, 2014, the Fund earned $122,651 from counterparties in securities lending income.* BTC and BRAL each received a portion of the total securities lending income earned from counterparties for their role as lending agents.

----


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## andrewf (Mar 1, 2010)

Pricing of XIU/XIC is an exercise in segmenting the market.

XIU has built substantial network effects from being the largest, most liquid ETF in Canada with the most liquid derivatives. iShares will charge those who want to enjoy those features, which are hard for other fund providers to duplicate in the near future, a higher fee. XIC is their 'flanker' ETF designed to compete for new assets from more passive, long-term investors for whom liquidity and optionability are not as important as having a broad exposure and low fee. 

This is really quite obvious, I think.


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## GoldStone (Mar 6, 2011)

andrewf said:


> Pricing of XIU/XIC is an exercise in segmenting the market.


It's not just segmenting. They know that taxable clients cannot switch to XIC. It's a time tested strategy for BlackRock.

EEM is the original iShares emerging markets ETF launched in 2003. It charges an uncompetitive 0.67%. IEMG is a newer iShares offering that tracks the same emerging markets. It charges 0.18%, in line with Vanguard VWO.

BlackRock had an option to drop EEM fees in order to compete with VWO. They chose to launch a new ETF instead. It sucks to be a taxable EEM client.

This is where Vanguard ownership structure really shines.


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## cainvest (May 1, 2013)

GoldStone said:


> Find "Securities Lending Income" and "Net Assets" in the annual report. Calculate lending income as a percentage of assets. Compare this number to other ETFs. This will give you an idea of how aggressive your ETF is with respect to security lending.


Thanks for the clarification and it does indeed appear, from the income generated anyways, that the lending percentage is rather small for the funds I'm interested in.


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## cainvest (May 1, 2013)

Did a little digging on the Securities Lending income vs Net assets for some Mutual funds (typical CDN bank offered no load types) and found a fair number inline with ETFs but others had some pretty high % numbers. Would need to take a bigger sample but looks like the common ETFs are generally looking better in this regard. It was kind of suprising to see this given the high MERs on those funds, guess they're always looking for ways to make more money.


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## humble_pie (Jun 7, 2009)

GoldStone said:


> BlackRock didn't lower XIU MER for one simple reason: it's their cash cow. Taxable XIU investors are trapped by the capital gains taxes. They grind their teeth and continue to pay the higher MER





GoldStone said:


> They [Black Rock] know that taxable clients cannot switch to XIC. It's a time tested strategy for BlackRock



wondering where you have got this idea?

i for one cannot believe this, unless you are able to back it up with independent* citations. 

it's widely known that XIU is a huge institutional favourite, with many unit-holding institutions being 100% tax-exempt pensions, charities, foundations & special trusts.

these funds would all dump their XIU for XIC in a wink if they believed that XIC were a better deal.

but they're not budging. There must be something about XIC that has repelled them.


* by "independent" i mean verifiable & reliable 3rd party sources


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## GoldStone (Mar 6, 2011)

XIC is not liquid enough for the institutional investors.


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## GoldStone (Mar 6, 2011)

humble_pie said:


> There must be something about XIC that has repelled them.


Money *is* flowing into XIC at a steady clip.










Note how assets stayed almost flat from 2010 from 2013. Note the big jump in the first half of 2014 after they cut the MER.

The healthy flow continued after June. Net assets as of yesterday: $1,811,729,825. Assets increased even though XIC is down 4% since June 30.

XIU *lost* assets in the same time frame:

Net assets as of 30/06/2014: $12,433,776,000
Net assets as of 23/10/2014: $10,781,139,774

XIU is down by the same 4%. Assets dropped 15%.


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## Ihatetaxes (May 5, 2010)

GoldStone said:


> XIC is not liquid enough for the institutional investors.


Exactly.

Even I have noticed its slower to move larger orders of XIC compared to XIU. I have bought a lot of it in the last two weeks (replacing XIU) and the volume is so far a fraction of XIU.


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## GoldStone (Mar 6, 2011)

cainvest said:


> Did a little digging on the Securities Lending income vs Net assets for some Mutual funds (typical CDN bank offered no load types) and found a fair number inline with ETFs but others had some pretty high % numbers. Would need to take a bigger sample but looks like the common ETFs are generally looking better in this regard. It was kind of suprising to see this given the high MERs on those funds, guess they're always looking for ways to make more money.


Good catch!


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## HaroldCrump (Jun 10, 2009)

GoldStone said:


> Harold, I think you grossly exaggerate the risk associated with security lending. The risk is miniscule compared to equities risk.
> ...
> You take your 80c-90c of the collateral, re-purchase the loaned securities 40c-60c on the dollar, and you pocket the difference.


GoldStone, you are dismissing the part about the MM freezing up.
Counter-party failure is one thing, but a frozen MM is a different (and exponentially larger) risk.

You are able to say easily that just redeem the collateral and buy the securities back.
Well, redeem the money market collateral to _who_?
_No one is buying._
That's the whole risk.

Unless the ETF fund has an internal cash balance equivalent to the third-party collateral (which would defeat the purpose of securities lending completely), they have no ability to redeem the MM and buy back the securities.
Think back to the period from August 2007 to about March 2009.
Precisely these types of money markets were frozen.
Do you not remember what the ECB, the Fed, and the Bank of England had to do?
Basically they said, we will accept any garbage collateral in exchange for liquid funds.
Mutual swap agreements were set up between the Fed, ECB, and many EM banks to enable each other to acquire foreign currency reserves.

In that link to Vanguard MM fund that you posted, I am able to count about 50% as truly liquid (the CDs, and the US Treasuries).
All the other stuff is OTC "stuff".
41% of the fund is in Yankee bonds and foreign bonds (which are effectively the same thing).

Anyhow, sophisticated investors such as yourself may understand the risks, accept them, or waive them away.
However, the vast majority of small, DY investors flocking to these funds simply do not understand these risks.
They don't have the ability of accepting the risks.
All they are doing is casually waiving them away.


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## humble_pie (Jun 7, 2009)

GoldStone said:


> Money *is* flowing into XIC at a steady clip.
> 
> Note how assets stayed almost flat from 2010 from 2013. Note the big jump in the first half of 2014 after they cut the MER.
> 
> ... XIU *lost* assets in the same time frame



the increase is merely due to the retail investors moving over, imho.

for years now, one can see retail investors everywhere - including on this thread - slavering like pavlov's dogs for ultra-low MERs.

so some retail have left XIU for XIC? how is that a big deal? anyone could have bet with 100% dead certainty that they would leave.


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## cainvest (May 1, 2013)

HaroldCrump said:


> However, the vast majority of small, DY investors flocking to these funds simply do not understand these risks.
> They don't have the ability of accepting the risks.
> All they are doing is casually waiving them away.


And this is the point I was trying to get at earlier which raises two questions,
1> How do you assess how much risk there really is on a fund by fund basis? 
2> What are your investment options if you don't like this level of risk?

As for question 1, does not the "Securities Lending income" indicate the level of exposure?

And the reason I ask the above questions is, if there are no clear cut answers to them, then the average DIY investor's hands are tied and this point is moot. Plus if ones only option is to buy equites directly that creates other siginificant problems.


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## cainvest (May 1, 2013)

Just took a peak at the TD e-series Canadian Index and if my math is correct, their Securities Lending % is 5-6 times higher than the equiv. iShares ETF.


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## HaroldCrump (Jun 10, 2009)

GoldStone said:


> June 30, 2014
> Securities Lending Agents
> 
> The Fund has engaged BlackRock Institutional Trust Company, N.A. (“BTC”) and BlackRock Advisors (UK) Limited (“BRAL”), affiliates of BlackRock Canada, as securities lending agents. To mitigate risks from securities lending, *the Fund benefits from a borrower default indemnity provided by BlackRock*, an affiliate of BlackRock Canada. *BlackRock’s indemnity allows for full replacement of securities lent*. BTC and/or BRAL bear all operational costs directly related to securities lending as well as the cost of borrower default indemnification. *For the six-month period ended June 30, 2014, the Fund earned $122,651 from counterparties in securities lending income.* BTC and BRAL each received a portion of the total securities lending income earned from counterparties for their role as lending agents.


This is all fancy industry-speak.

Due to the rampant practice of securities lending, the situation is such that all the large financial institutions, banks, hedge funds, etc. are in on this game.
The net result is that large players like JP Morgan, Deutsche Bank, Credit Suisse, etc. are playing multiple roles in this game.
At any given point in time, the same institution (I'm going to pick on say Deutsche Bank because of their large derivatives exposure), is playing all 3 roles - the lender, the borrower, and the securities lending agent, albeit for different trades and different clients at a time.
D/B has a very large lending agency line of business.

Add to it the fact that bonds and ST commercial loans issued by these institutions comprise a part of the collateral submitted as insurance for the lending in the first place.
The risk of contagion is exponentially greater.

As for this indemnity clause - it is not a panacea.
There are no regulations or governance around these clauses.

*This report from the Bank of Canada *agrees that the indemnity provisions are often left in the hands of the securities lender, borrower, and the lending agent.



> beneficial owners are indemnified against losses resulting from a borrower's failure to return the loaned securities, for any reason, within the specified time period.
> In other cases, beneficial owners are indemnified only against losses incurred as a result of an insolvency-related failure to return securities.
> The contractual wording of the indemnity provides the specifics


In other words, this indemnity clause is the thin thread that the end investor is hanging by, but that has been left entirely to the participants.

In the same document, the bank admits how these iron-clad collaterals spiraled downwards during 2008:



> Certain cash-collateral programs proved more problematic than non-cash programs for some of the same reasons discussed in the previous section.
> These cash-collateral programs added to deleveraging pressures by liquidating investments (to meet security loan recalls) at a time when markets were highly illiquid and the demand for investment assets was extremely low.
> This had a negative impact on asset prices and contributed to their downward spiral.
> As asset prices continued to decline, leading to losses in cash reinvestment pools, many beneficial owners decided to suspend their securities-lending programs to re-examine the risks.
> ...


In other words, the counter-party risk is very real, and experienced before.
That time, only a historical injection of liquidity, bailouts (TARP, etc.) and unlimited guarantee by the various governments prevented a meltdown.

_There is no investor protection whatsoever, and the regulators know it._
The Bank of Canada says this about regulation and oversight:



> The guidelines may be most effectively drawn up and implemented through the collaborative efforts of participants in the securities-lending market, including agent lenders, beneficial owners, and borrowers.
> Discussions among market participants brought together through various securities-lending associations would provide a good starting point.
> *However, enforcing and monitoring the implementation of such best-practice guidelines may be challenging*.


^ see how wishy-washy and noncommittal it is?

The paper is a little dated by now (2010), and it seems in 2012 some half-hearted regulations were brought in by the CSA to "regulate" securities lending in Canada.
But those regulations (no doubt egged on by the industry) seem to have - if anything - made it easier and more liberal to lend securities.

Basically, at this time, the entire weight of investor protection is resting on two things - the indemnity clause in the lending contract, and the liquidity/strength of the collateral.


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## GoldStone (Mar 6, 2011)

Harold, you are thinking about Armageddon scenario that is worse than 2008.

Equities would be absolutely decimated in any scenario where MMF collaterals are frozen or impaired. It is disingenuous to pretend otherwise. All equity investors would be wiped out. ETF investors, mutual fund investors, and yes, direct stock holders too.

We already established that ETFs earn a very modest revenue from security lending. It was less than 0.1% of NAV in all cases I looked at. This should tell you how limited the practice is. Does lending add extra risk to the ETF? In theory, yes. In practice, 99% of risk comes from owning equities. Direct stock holders are exposed to the same risk.

We also established that bank-owned mutual funds lend equities too. In fact, they lend higher percentage of their holdings than ETFs. Paying 2.8% MER does not immunize you from the lending risk. Quite the opposite.

Harold, this thread is about Vanguard lowering fees on 11 funds. This is great news all around. You want to rant about security lending? That's fine. Just don't pretend that the practice is somehow linked to the ETF cost-cutting. It is not.


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