Pension fund executives need to pay attention any time their vendors of money management services start to reduce fees to near zero - a trend in stock index-fund management for large accounts.
When services are practically given away, that could be a symptom of new potential risk.
Pension funds have billions of dollars invested in stock index funds and other passive investment portfolios. Yet many of the banks and other institutions are "using" the assets in a very active way. They are using the assets for securities lending activities.
Fees for index fund management have fallen dramatically in recent years, a Pensions & Investments report noted. Many of the banks lowering the fees have sought to make up the forgone revenue by lending the securities in the index portfolios.
Plan sponsors need to look at how these sources of revenue for vendors affect the pension funds' index fund investments.
A pension fund typically pays "two basis points on accounts up to $100 million and sometimes nothing after that, with the expectation that money will be made on securities lending," according to an executive with one indexer quoted in the report.
The intense competition in indexing that is driving down fees is reminiscent of the similar forces that began a few years ago in the custodial business.
"Those services are routinely priced at zero," the recent P&I story said. "The custodians get the assets to lend and make their revenues from that."
Securities lending in itself is a worthwhile way to generate incremental investment income. But this once-staid activity can be done too aggressively.
When competition among custodians was becoming intense, several custodial banks reported significant losses in their securities lending portfolios. The losses for an activity normally not discussed in detail were material enough for some banks to have to disclose them and announce publicly they would keep clients whole.
How risky securities lending is depends on how aggressively the money received from lending securities is invested. Pension funds need to understand what risk they share for these activities and whether the vendor will cover any potential losses.
Interest rates and the yield curve have been favorable for such activity, noted one index fund manager in an interview. But what if the market conditions change? That's what happened to the custodial lenders a few years ago, he said.
In the mutual fund world, a P&I story this summer reported, Fidelity Investments cut rates on its index funds, trying to price them more competitively with those of The Vanguard Group, the biggest and lowest priced index fund manager among mutual funds.
Investors should ask: Does Fidelity have the same cost structure as Vanguard. One has doubts, because of Fidelity's different corporate ownership structure and longtime commitment to active money management. Active management, with its staffing of analysts and portfolio managers, is necessarily more expensive to operate than passive management.
That apparent reality might help explain why Fidelity contracted with Bankers Trust Co., a major index manager, to use it as a subadviser for passive investment management services.
Not all bank or other index fund managers compete for the low-priced business, or use securities lending to raise revenue. But a number of big index fund managers do.