On the surface, investing in a mutual fund seems pretty straightforward. However, even buying the most basic index fund can be filled with a variety of subtle nuances. From various fees tucked inside the overall expense ratio to slight differences in underlying benchmarks, there are actually a lot of moving parts behind owning and running a mutual fund, and one of the major ones could be considered a tad bit insidious.

Hidden from most investors’ knowledge is the practice of securities lending, and for most funds, that’s a steady source of cash going right into their bottom lines. Cash that according to some critics should be going right into the fund owners’ pockets. But what exactly is securities lending and how does the average mutual fund use the technique? Read on to find out.

Be sure to also read A Brief History of Mutual Funds.

To understand the concept of securities lending, first you have to be familiar with the idea of shorting a stock. In a short transaction, an investor is making a bet that the value of a certain stock will fall. They will sell shares of the stock they don’t own and at a later date cover the position by buying back the shares. The difference between when they sell and when they buy is their profit on the transaction. If the stock goes up, they lose money.

Traditionally, when an investor shorts shares, the stock they are using is borrowed from their broker. In recent years—as trading has become more popular—that borrowed stock has come from some of America’s largest mutual funds.

Securities based lending is basically the process whereby a mutual fund, insurance or other pension fund will hand out its shares to other investors to short. Under a fund’s securities lending program, the investor borrowing the shares provides some sort of collateral to the fund and the fund earns a bit of extra fee income. Mutual funds—along with exchange traded funds (ETFs)—are quickly becoming big-time players as they feature large and relatively static portfolios. According to the Federal Government’s Financial Stability Oversight Council (FSOC), mutual funds currently comprise about 35% of the total amount of securities lending and borrowing. However, that number continues to surge upwards.

Now, the Securities & Exchange Commission does regulate securities lending within mutual funds. A mutual fund must publicly disclose that it may lend securities. That info will be in the prospectus. Additionally, a fund will prepare financial statements twice a year. These statements—filed with the SEC and made available to shareholders—show what securities are out on loan, investment of the collateral, a liability reflecting the obligation to return the collateral at the conclusion of the loan, and income earned from securities loans.

Be sure you are familiar with How to Read Your Annual Mutual Fund Report.

Securities lending is highly lucrative – mostly for the mutual fund sponsors. Fees generated from such programs are layered on top of fees received for managing the funds. That’s basically free money. And there’s no hard and fast rules on what the fund sponsors must do with that cash. More often than not, mutual fund managers will retain the bulk of that as extra profits. For example, investment manager BlackRock keeps around 35% of all its securities lending revenue. Some critics have argued that since investors technically own the shares of the underlying stocks and they are taking the risks, they should be the ones receiving the fee income.

And there are some risks.

When a fund lends the stocks, these assets are not actually part of the fund, the put-up collateral is. Typically, U.S. Treasuries or cash is used. However, in recent years everything from mortgage backed securities and derivatives to letters of credit and other exotic I.O.U.’s have become commonplace. These sorts of instruments fluctuate in price and must be marked-to-market daily. That can actually affect the net asset value of the mutual fund if they swing rapidly. An additional risk is if the mutual fund invests that money in something less than desirable to juice returns.

Secondly, if the collateral drops in value by too much, the investor borrowing the shares may be forced to add additional collateral or cover the short early. If they can’t, the mutual fund and its investors are on the hook for the damage.

While mutual fund investors don’t get all that gravy from securities lending, they do get some benefit from it. It can be a source of extra returns if done properly. The collateral can be invested, and if a short is profitable, it can save the mutual fund from losses it would have incurred from holding that stock.

It can also help reduce the overall expenses of the fund as well. Mutual fund sponsor Vanguard gives 100% of its fees generated from securities lending back to its shareholders. This is one of the main reasons why Vanguard is able to offer rock-bottom expense ratios. In some cases, fees from securities lending pays for virtually all of the mutual fund’s operating costs.

See our list of the Cheapest Mutual Funds for Every Investment Objective.

Many investors are unaware of what takes place behind closed doors at their mutual fund. Securities lending programs are just one example. By lending various stocks or other assets for shorting, mutual funds have a chance to boost returns and make a handsome profit for their fund sponsors. While it’s not without its risks or controversy, if done properly, it can be a great win-win for investors and fund managers alike.

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