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%.
IWM has a 0.20% expense ratio, TWOK has a 0.12% expense ratio and VB has a 0.09% expense ratio, so securities lending activity appears quite robust to compensate for ETF fees and beyond.
Securities lending is a practice where mutual funds and ETFs pay agents to lend out shares in their portfolios – the funds represent a 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.
In most cases, ETFs would 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.
Max Chen contributed to this article.