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.
For a larger view, please click on the image above.
Sources: Annual reports, statements of additional information, issuer websites, ETF.com
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.
How Much Do ETF Investors Benefit?
What benefit from securities lending exists for the end investor directly depends on how much of the associated revenue makes it back into the fund.
Most ETF issuers return to the fund 100% of the money made through their securities lending programs. Others retain some portion of those funds for the issuer.
Vanguard, for example, serves as its own lending agent, charging itself fees amounting to about 5% of gross securities lending revenue. The remainder is returned to the funds.
State Street, however, returns 85% of generated securities lending revenue to the SPDR funds, reserving the rest for State Street affiliates. (One notable exception is the SPDR S&P 500 ETF Trust (SPY), which, as a unit investment trust, cannot engage in securities lending.)
However, BlackRock reserves 25-28.5% of the securities lending revenue made on U.S. equities for the BlackRock affiliate it uses to handle the securities lending, BlackRock Institutional Trust Company (BTC). For other securities types, the portion is 15-20%.
BTC also charges iShares ETFs up to 0.04% of the on-loan amount in additional fees and expenses to handle the management of the collateral. That collateral is invested in money market funds managed by BlackRock Fund Advisors, an affiliate that also serves as the investment advisor to the iShares ETFs.
Potential Conflict Of Interest
Though ETF issuers often claim securities lending is a boon for investors, the reality is slightly more complex. Securities lending does boost ETF returns, but it’s a rare ETF where this additional revenue will be large enough to be noticed by most investors.
But securities lending activity can be meaningful to the bottom line of the issuer, at least for those that lean on affiliates for lending and collateral investment.
Whether this generally leads to a conflict of interest is difficult to say. In general, a well-run securities lending program benefits investors, even if the benefit is slight, and the extra revenue incentivizes issuers to maximize the opportunities on behalf of investors.
There’s no guarantee a given affiliate in charge of securities lending or managing collateral is the absolute best possible choice from an investor perspective. Ultimately, ETF investors simply have to trust the fund’s board is monitoring and evaluating these relationships for their benefit, not the issuer's.
[Editor's Note: Investors can learn whether a given fund lends its securities by checking its ETF.com Fund Report, under the "Efficiency" tab. The "Securities Lending Active?" field on the right sidebar will display "Yes" if the fund is currently engaged in lending out securities. Investors can also find out how much revenue is returned to the ETF versus the issuer in the "Securities Lending Split (Fund/Issuer)" field.]
Contact Lara Crigger at [email protected]