Understanding Securities Lending

Securities lending is a fairly simple process that can generate extra returns for ETF investors, but it also introduces extra risk—however minimal.

The logic behind securities lending is this: An equity ETF will typically hold thousands of shares of various stocks. If there is a short-seller out there who wants to borrow those stocks—and agrees to post collateral and pay the ETF a fee for doing so—why not lend them out and make a little extra dough?

Generally speaking, securities-lending activities are positives for shareholders and contribute to tighter index tracking and better overall returns. They are not without some risks; while we believe they are generally minor, they are nonetheless worth considering.

The Risks Of Securities Lending

You’d think the biggest risk in securities lending is that the short-seller you lent shares to goes bankrupt. Fortunately, industry practice is for borrowers to provide collateral exceeding the value of the loaned securities by a set margin. So while a busted counterparty is a pain, it’s not immediately costly.

The costs come in if the borrower is a short-seller (it usually is) and the security that he or she shorted rallies strongly in a single day, the borrower defaults and the provided collateral is insufficient to cover the cost of reacquiring the security. Remember, collateral balances are only settled (at best) daily.

Even that is small-fry, however.

The real risk with securities lending is that when ETF issuers receive cash collateral, they don’t just sit on it—they put it into money market securities to earn some small amount of interest on the cash. Where firms get into trouble is when these collateral investments go bankrupt, such as when Lehman Brothers went under. It’s unlikely, but it has happened.

How Profitable Is Securities Lending?

It depends. Just as prices in the rest of the economy are subject to the forces of supply and demand, so too are securities-lending premiums.

Securities that are in high demand in the loan market command higher premiums. ETFs that hold these in-demand securities can earn a significant premium lending out portfolio holdings. Premiums tend to fluctuate as certain sectors, markets or countries fall in and out of favor with short-sellers.

When these factors align perfectly, ETFs can earn huge premiums for lending securities. Historically, some ETFs (those in solar in 2013, for instance) have paid dividends amounting to a yield as high as 5-7 percent despite the fact that none of their underlying holdings paid dividends. In these cases, the ETF generated sufficient revenues from securities lending alone to enable a hefty dividend for its investors.

Let’s keep things in perspective though; most ETFs don’t earn such lofty premiums for lending their securities. While they certainly provide a tail wind for ETFs, the effect of securities-lending revenue is usually relatively muted and generally serves to offset expenses rather than generate significant outperformance.

It’s worth noting that, rather than distributing securities-lending revenue as dividends, the usual course of business is for ETFs to invest the extra revenue in its portfolio holdings. In this case, investors reap the rewards via fund performance rather than dividend payments.

The takeaway is that securities lending introduces some risk to ETF portfolios—much of which has been mitigated by issuer policies. Meanwhile, the benefits of securities lending range from negligible to highly significant.

Next: Managing And Avoiding ETF Closures

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What Is An ETF?