Expenses and management fees, no matter how small, will put a slight drag on an exchange traded fund’s performance, compared to its underlying benchmark index. However, many ETFs have been able to match their benchmark returns, even outperforming them. That’s where securities lending comes in.

Simply put, an ETF generate some extra cash on the side by lending out shares of its underlying holdings to another party for a price, writes Morningstar analyst Abby Woodham. The lending practices have helped sponsors tighten the performance difference between the ETF and the benchmark and lower a fund’s expense ratio.

Securities lending is a practice where mutual funds and ETFs pay agents to lend out shares in their portfolios – the funds are created with exposure to an underlying basket of securities – to other traders and thereby earn interest.

The holder temporarily transfers the security to another investor in exchange for collateral, such as cash or other securities equal to 102% to 105% on  of the shares’ value. If the ETF needs to sell stock, it can take it out of the borrower. If the borrower is unable to deliver the shares, the ETF uses the collateral.

Typically, ETFs lend securities to investors who want to short a stock. The investors would have to borrow shares from the provider and sell them on the market, hoping that when it comes time to give the shares back, they would be able to repurchase shares at a lower price in the market and pocket the spread.

Showing Page 1 of 2