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A tourist mounts the "Charging Bull" statue as he poses for a photo near Wall Street in New York on Jan. 16.

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Brad Lamensdorf is an unlikely whistle-blower on the inner workings of exchange-traded funds.

A hedge fund alumnus and now chief executive of a tiny ETF startup, Mr. Lamensdorf has long been aware of the sometimes embarrassing secret at the heart of these funds: securities lending. Now the expert in so-called long-short strategies -- buying stocks expected to increase in value while selling those projected to fall -- is shining a light on the practice with his newest fund, and trying to make a buck for investors at the same time.

ETFs often lend out up to a third of their holdings in return for a fee and collateral. Those payments from borrowers that want to make a bet on a security then contribute to the fund's returns.

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Most issuers don't say much about this practice, fearing the additional risk it implies may scare off investors. But Mr. Lamensdorf, whose Westport, Conn.-based Active Alts Corp. buys stocks deemed overly short in anticipation of a squeeze higher, sees it as a selling point. (A short squeeze is when bears who've borrowed shares to sell short are forced to buy them back because of a market rally.) The revenue the fund gains from lending out its holdings offsets the risk that those maligned securities will slump further.

"The average investor doesn't think about this and so a fund that is highlighting this aspect is distinct," said Todd Rosenbluth, director of ETFs and mutual funds at CFRA Research, an independent research provider. "Whether or not people will gravitate to it because of its increased transparency, that isn't happening today. I think that will only happen if they're able to deliver above average returns."

Extra Returns

The Active Alts Contrarian ETF, which has the ticker SQZZ, has lost 0.6 per cent since it started in March, and has gathered less than $1-million in assets. It's charging 195 basis points -- significantly higher than the average 50 basis points for U.S. stock ETFs -- although the fund's board will consider dropping the fee to 125 basis points on June 23, Mr. Lamensdorf said.

While lending rates vary depending on borrower demand, the practice can bring in serious cash. Shares of oil and gas explorer Sanchez Energy Corp. for example had a 38-per-cent annualized interest rate as of June 21, according to Lamensdorf. About 30 per cent of its shares are held short, according to Markit data.

This income can significantly improve a fund's performance by offsetting its management fee, which acts as a drag on returns. For example, stock lending by BlackRock Inc.'s iShares Russell 2000 ETF -- which has the ticker IWM -- added 26 basis points to returns in the fiscal year ended March 2016, six basis points more than the fund's annual expense ratio, company documents show.

Short Changed?

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But that could have been more. BlackRock gives between 71.5 per cent and 80 per cent of lending income to its ETFs, depending on the underlying asset class, and covers costs with its share, a company presentation shows. State Street Corp. gives 85 per cent of the proceeds to its funds, according to financial statements. Vanguard Group Inc. meanwhile says it lets its funds keep all net revenue from security lending.

Freddy Martino, a spokesman for Vanguard, said "securities lending is a portfolio management activity of the fund, so the fund shareholders deserve to receive the proceeds." BlackRock spokeswoman Melissa Garville said the company focuses on delivering competitive returns while balancing return, risk and cost for its clients. A representative for State Street was not immediately able to comment.

As for Active Alts, Lamensdorf said his broker will take 15 per cent for arranging the loan, with the remaining profit flowing back to the fund. He also urged investors to pay closer attention to what ETF providers are doing with their holdings.

"People don't realize how much these companies are taking from them," Mr. Lamensdorf said during an interview at Bloomberg's New York headquarters earlier this month.

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