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.
However, securities lending has been associated with counterparty risk. If a borrower, for whatever reason, does not return the shares, the ETF would be left in a short squeeze.
On the provider side, ETF sponsors usually receive collateral in the form of cash or other securities. Consequently, fund companies can reinvest the cash or lend out the securities, but they usually steer toward conservative bets like short-duration, low-risk assets. However, other fund providers may invest collateral in overly risky instruments, leaving investors at risk. Some providers, though, compensate their ETFs in case of losses due to share lending.
Some ETF sponsors, like Vanguard, return all profits back to its funds, minus fees. However, some others only return a portion of profits – iShares takes 20% to 30% of revenue and State Street takes 15%. Last year, two pension funds filed suit against iShares for taking excessive profits on securities lending, but the case was later dismissed. [Court Dismisses Securities Lending Suit Against BlackRock]
For more information on ETFs, visit our ETF 101 category.