Blocher & Whaley on Passive Investing

Jesse Blocher and Robert E. Whaley have posted Passive Investing on SSRN with the following abstract:

Financial economists have long touted the benefits of passive investing, but see it as a lower cost subset of active investing. Instead, we show that passive fund managers have a fundamentally different business model than active fund managers, similar to a media/advertising model where the product (entertainment/news) is given away and the audience is monetized to generate revenue. Specifically, we show that Exchange Traded Funds (ETFs) derive most of their profits from securities lending, while charging a minimal expense ratio. Findings for passive index mutual funds are similar, but attenuated. ETF managers respond to these incentives by slanting their holdings toward more profitable to lend stocks. Investors see a small benefit, as securities lending revenue is associated with somewhat lower deviation from the underlying index.