Risky ETF Securities Lending?

July 25, 2011

Securities lending is generally hailed as a boon to ETF portfolios. But it’s worth pointing out potential risks.

 

ETFs, by their very nature, have big baskets of their underlying shares sitting around. So, the thinking behind securities lending goes, if someone wants to borrow a few of those shares, why not lend them out for a fee and make an extra buck for the fund? The problem is that people might say yes without understanding all the risks.

Don’t get me wrong: I don’t want to come off as a Chicken Little. The risks associated with securities lending are small. But they are real. In a perfect storm—particularly in funds that have upward of 10 percent of the portfolio lent out—there could be real damage.

It’s always helpful to do a quick review of the risks of securities lending, which are twofold.

The first risk is the most obvious—that whomever you lent your securities to will not return them. That risk is generally well averted by ETFs. The industry standard is that any shares lent out must be collateralized by cash equal to at least 102 percent of the value of the securities, marked-to-market daily.

A big jump in the price of those shares could cause the value of the shares to surpass the face value of the collateral held against them. If the fund is forced to liquidate the collateral it received for the borrowed shares, and then must go into the market to buy shares, ETF shareholders would be responsible for the difference between the value of the collateral and the shares.

How often this situation crops up in ETFs isn’t clear, but I haven’t seen anything to suggest it happens very often, or on a large enough scale, to have any meaningful impact on a fund’s returns.

The other risk of securities lending stems from the big pile of cash portfolio managers get as collateral for the shares they’ve lent out.

ETF portfolio managers—like good money managers everywhere—aren’t going to stuff cash under the mattress. Instead, they take the cash collateral they get from lending out shares and reinvest it into a money market mutual fund. That lets them earn interest on the cash, which is theirs to keep when the lent securities are returned.

The problem is money market funds aren’t savings accounts, even if the world treats them as such. So, if anything in those cash-equivalent funds goes bust, ETF shareholders could be on the hook for the loss.

Case in point: According to a Van Eck annual report, the fund company said it lost a total of $582,593 in its Russia ETF (NYSEArca: RSX) because it owned paper in a money market fund. They’ve since entered into a capital support agreement with BNY Mellon to recover 80 percent of that.

To be clear and sober, that’s a tiny loss in percentage of assets—RSX currently has more than $3 billion sitting in it.

Still, it serves as proof that securities lending isn’t all upside and no downside. That said, having pored over a number of ETF annual reports, I can say that very few funds have actually lost collateral due to a money market fund breaking the buck.

That held true over the most devastating financial crisis since the Great Depression. Still, let’s not forget that after the Lehman failure, a run on corporate money market funds took shape.

The U.S. government stepped in to guarantee money market funds and stop the run, but without that guarantee, it’s not clear how ETFs putting securities lending collateral to work would have fared.

At the end of the day, securities lending programs add an extra dash of risk to an ETF that a lot of end-investors probably aren’t aware they’re taking. Does that risk end up boosting fund returns most of the time? Absolutely. Such programs also pump up profits for fund companies, as most issuers keep a portion of the revenue from their share lending. It’s not clear, however, that those same companies will return any of those profits if their securities lending activity were to take a loss.

So, do I mind if shares of ETFs I own are lent out? Not if it’s done right. For me, that means investing cash in money market funds that hold only government obligations.

ETFs that go chasing yields at the riskier end of the money market spectrum are probably overstepping the line, though. At the end of the day, ETFs are about exposure to a targeted market. There’s no need to muddy that in the search of a few basis points of extra return.

 

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