Reinvested Collateral Can Make Money …
Issuers claim that, between the premiums paid by borrowers and the income generated from reinvestments, securities lending generates enough revenue that many ETFs can outperform their expected return. Securities lending revenue, they say, helps offset the drag on returns introduced by a fund's expense ratio.
To a certain extent, this is true, though the profitability of securities lending—and thus its performance boost—varies greatly from fund to fund. A fund that happens to own stocks that are in demand by short-sellers will have much greater opportunity to generate lending revenue than one consisting solely of blue-chip mega-caps.
One example of an ETF that earned sizable income from securities lending is the Guggenheim Solar ETF (TAN).
In the 12 months ending Aug. 31, 2017, TAN lent $111 million of solar stocks, generating a net investment income of $4.61 million (Guggenheim's 2017 Annual Report for TAN and other ETFs.) That's almost twice what the fund earned from dividends generated by the underlying stocks in its portfolio.
Though that securities lending income amounted to just 1.3% of TAN's total net assets over the 12-month period, it was more than enough to offset the fund's 0.70% annual expense ratio.
…Yet Most ETFs Make Just A Little
Although some ETFs earn significant income from lending out their securities, the vast majority of ETFs earn back just a small portion of their expense ratio.
Take the $1.2 billion ETFMG Prime Cyber Security ETF (HACK), which loaned out roughly $234 million worth of securities in its portfolio during the year ending Sept. 30, 2017. From that, the fund earned net income of just $489,967 (ETFMG 2017 Annual Report).
That's 0.04% of the total net assets of the fund, whereas HACK's expense ratio is 0.64%. Four basis points isn’t nothing in the world of ETF expense ratios, but for a fund arguably at the high end of expenses, it’s pretty marginal.
Or consider the State Street Select Sector SPDR ETFs. The Consumer Discretionary Select Sector SPDR Fund (XLY) loaned out $263 million worth of securities during the year ending Sept. 30, 2017 (the State Street Select SPDR ETF 2017 Annual Report is available for download here). From that lending activity, XLY earned a net $1.3 million—which represented just 0.01% of the fund's $11.5 billion in net assets for that period. That offsets XLY's 0.14% expense ratio only minimally. Other funds in the Select Sector SPDR suite saw even lower securities lending revenues.
In a recent white paper on securities lending, BlackRock acknowledged that 81% of its iShares ETFs that lent out securities in 2017 made 0.05% of the ETF's total net assets or less; 39% made 0.01% or less. In contrast, the average iShares ETF expense ratio is 0.35%.
Securities Lending Agents Profit
What small revenue ETFs bring in from their securities lending programs is reduced further by the cost of the program itself.
Securities lending agents, who facilitate the lending activity and manage borrower collateral, charge some fee for their efforts—typically some fraction of the total income generated by the securities lending activity.
Therefore, even if the securities lending income for a given ETF is small relative to its assets, the lending agent may still see significant revenue, especially since one party typically serves as securities agent for an issuer's full fund family.
Many ETF issuers turn to their fund custodians to act as their securities lending agents. ALPS, Deutsche Asset Management, ETF Managers Group, Global X, Guggenheim, Index IQ and WisdomTree all rely on their fund custodian to be their securities lending agent (see Table 1).
Boost From In-house Securities Lending
The largest ETF issuers, however, often bring securities lending in-house. The big three—BlackRock, Vanguard and State Street—all use affiliates of their parent company as their fund's securities lending agents.
Furthermore, many ETF issuers invest their collateral into money market funds managed by the investment advisory affiliate of their parent company. Companies doing this include the big three mentioned above.
State Street even offers money market funds rival ETF issuers sometimes use to invest their collateral, meaning State Street may make money on securities lending even if its own ETFs do not.