ETF securities lending explained
Securities lending is a common practice that ETF providers use to boost returns for investors. They do this by loaning stocks and bonds to large financial institutions in exchange for a fee. We explain the basics so that you can understand the risks and rewards attached to investing in an ETF engaged in securities lending.
Although exchange traded funds (ETFs) have been around since the 1980s, their popularity has surged in recent years as savvy investors have become increasingly aware about the negative impact management fees can have on returns. As the vast majority of ETFs are cheaper than actively managed funds, this has recently led to large inflows into this type of passive product. A record $66.3 billion flowed into ETFs in March 2017, bringing the total amount invested globally to around $3.9 trillion.
As the value of assets held in ETFs increases, the pool of stocks and bonds held by each fund also grows. And just as a big high street bank can choose to lend cash to businesses or individuals, an ETF provider may decide to lend out some of the stocks and bonds to financial institutions that use them to hedge their portfolios, sometimes for a short period of time.
Investment banks and hedge funds are just a few examples of organisations that may want to borrow these securities. For the privilege, they must provide the lender (the ETF) with collateral — normally between 102% and 105% of the value of the loaned securities and also pay a fee.
The ETF will then pass on a portion of this income to investors, increasing the potential returns for shareholders.
What are the benefits?
The main benefit of securities lending is the added income that is generated for shareholders. The return will vary by asset class and depend on the demand for the underlying security at the time, and you should always remember that returns generated in the past do not guarantee those in the future. Potential extra revenue does not come without some risk.
However, a paper published by Vanderbilt University found that under different assumptions, on average ETFs made a return of 0.23%-0.28% per year from securities lending, while the average expense ratio for the sample of ETFs they used was 0.26%.
In other words, revenue from securities lending can be used to offset a meaningful proportion of the ETF’s management fee, and sometimes even make it free to hold.
An example of IG Smart Portfolios holding is the iShares Core FTSE 100 ETF (ISF), which has an annual management fee of seven basis points. In 2016, income from securities lending would have reduced this by 2.5 basis points — or 39%. By comparison, the iShares MSCI Emerging Market Small Cap (IEMS) earnt 49.5 basis points, bringing the management fee of 74 basis points down by a whopping 67%.
What if a stock pays a dividend while it is out on loan? No need to worry, shareholders will retain rights to dividend payments as well as other corporate actions and voting rights.
What are the risks involved?
The main risk involved with securities lending is borrower default risk. This happens when the borrower fails to return the stock or bond to the lender. If this occurs the fund will use the collateral provided by the borrower to repurchase the securities.
Although the fund should undertake rigorous due diligence before lending to another party, and as such the risk of default is rare, in the event that the collateral fails to cover the amount required to repurchase the loaned stocks or bonds, the fund could experience a loss.
However, in the event of a borrower default, the ETF provider may guarantee to refund any losses incurred. For instance, BlackRock states on its website that:
‘As an additional safeguard, BlackRock provides an indemnity for its ETFs in the event of a borrower default — if a shortfall existed between the collateral and the cost to repurchase a loaned security, BlackRock would reimburse the fund in full.’
Another criticism is that securities lending is opaque and often misunderstood by investors. Unusually, ETFs seem to have been singled out for such disproval, even though the majority of securities lending is actually transacted through actively managed funds. Nevertheless, details of ETFs participating in securities lending should be clearly listed on the fund’s website. If you can’t find this, you can always ask your provider to assist you.