Exchange traded funds have been touted as a low-cost investment vehicle, and some options are already providing investors with a free lunch.
Expenses or management fees, no matter how small, will put a slight dent on an ETF’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.
An ETF can generate some extra cash by lending out shares of its underlying holdings to another party for a price. The lending practices have helped fund sponsors tighten the performance difference between ETFs and their benchmarks, or negating a fund’s expense ratio.
ETFs can lend out as much as 33% of their equity holdings to short sellers in return for a fee, which may be funneled back to investors to offset a fund’s expense ratio, reports Eric Balchunas for Bloomberg.
In some instances, demand for securities found in an ETF’s underlying portfolio are so high that revenue generated from lending fees may exceed the fund’s expense ratio. ETF investors benefit from this increased securities lending as the generated fees help push returns above those of the underlying indices.
For instance, the small-cap ETFs show some of the largest positive gains to their benchmarks. Small-cap stocks are more difficult to come by, compared to the more liquid large-cap stocks, and demand for the riskier asset category is higher because the potential payoff is greater among short sellers seeking to turn a quick profit.
According to Bloomberg data, the iShares Russell 2000 ETF (NYSEArca: IWM) and SPDR Russell 2000 ETF (NYSEArca: TWOK) have outpaced the Russell 2000 Index by 0.21% and 0.07%, respectively, while the Vanguard Small Cap ETF (NYSEArca: VB) has outperformed the CRSP US Small Cap Index by 0.03%.