Securities lending is the best-kept secret in the ETF business.
Even the most sophisticated investors are unaware that 60% of all U.S.-listed ETFs can and often lend out the securities within their portfolios.
Issuers say that the practice helps them offset costs and improve fund performance. For the majority of ETFs, however, the revenue boost gained from securities lending is minimal, and barely impacts investor costs, even for funds that lend hundreds of millions of dollars in securities from their portfolio.
In a fee war over a few basis points, though, it might move the needle for the most cost-conscious investors.
That said, there’s little doubt fund issuers themselves can benefit from securities lending, even if their end investors might hardly notice.
What Is Securities Lending?
At its core, securities lending is loaning out the securities in a portfolio in exchange for some form of compensation. The practice goes back decades, if not longer, and is common in mutual funds, endowments and pension plans—any place that accumulates a large, fairly stable portfolio of securities.
Funds—and issuers—can make extra cash by lending securities to borrowers, usually short-sellers looking to profit from a decline in the value of those stocks. They borrow the stocks, sell them short, and wait for their values to decrease before buying those stocks back to cover. Because selling something you don’t own—naked shorting—is generally against the rules, short-sellers must first find someone to borrow a stock from.
Every securities lending agreement is different, but typical agreements require the borrower pay a fee to the fund issuer, and also post collateral. This collateral can be stocks, Treasuries, other high-quality debt or—most commonly—cash.
Loans Are Over-Collateralized
Whatever form the collateral takes, however, by law it must be equal to or higher in value than the market value of the borrowed securities. Most ETF issuers require collateral at least 102% of market value for U.S. stocks, and 105% of market value for all other securities.
This protects lenders in case of borrower default, the primary risk whenever lending transactions occur. The “extra” collateral acts as a buffer, should there arise a lag between when the issuer is notified of default and when they can deploy the collateral to "rebuy" the position.
The fund retains ultimate ownership of the stock and any performance gains; and because the loan is over-collateralized, it carries very little risk for the lender. (Borrower defaults are extremely rare, and ETF.com has been unable to find a single instance of a mutual fund or ETF whose net asset value (NAV) was impacted by borrower default.)
Limits Are Security Lending
When borrowers return the securities, they then get back their collateral. Until that time, however, ETF issuers often reinvest any cash portion, usually into repurchase agreements or low-risk money market funds, where it can generate income that the ETF gets to keep (non-cash collateral can't be reinvested).
However, there are limits on the securities lending. The SEC stipulates that the total value of borrowed securities may not exceed one-third of the fund's total market value. In practice, though, most ETFs lend in quantities well below this threshold.
According to ETF.com data, there are 1,281 ETFs from 20 separate ETF issuers with explicit securities lending policies in place. Table 1 lists the firms that engage in the practice and the details of how they do it.
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Sources: Annual reports, statements of additional information, issuer websites, ETF.com