Are Zero-Fee Funds Free?

Abstract

I build a model of delegated asset management where funds distribute security lending revenues either through a fee discount or by paying dividends. Lending revenues increase in short-selling demand and reduce portfolio risk. However, even competitive funds do not internalize this hedging benefit. Fee discounts are sub-optimal: they allow investors to extract the expected lending revenue, but not the hedging component. Zero-fee funds emerge in equilibrium if lending revenues are opaque, signalling a moral hazard problem. A drop in operating costs reduces moral hazard as funds increase transparency in the attempt to attract inflows -- consistent with observed robo-advisors' behaviour.

Keywords: passive investing, exchange traded funds, security lending, management fees,moral hazard, robo-advisors

JEL Classification: G11, G14, G23