Specifically, some observers are concerned about the quality of collateral an ETF accepts when it lends out its underlying securities to an outside investor. A holder would temporarily transfer a security to another investor in exchange for collateral, such as cash or other securities above 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. However, some worry this would not be enough in more volatile conditions.
“I see a number of physical ETFs that often have the majority of their securities out on loan with seriously mismatched collateral – for example, holding equity collateral against government bonds on loan,” Seager-Scott said. “Day to day, this tends not to have an impact – but it could well do if we had another market crisis.”
Furthermore, cash is often used as the collateral of choice, with the ETF provider investing the cash to try and generate even higher returns than just sitting on it and receiving a fee, which adds a level of risk as well.
“You have to invest the cash to get a return and even the lowest risk investment can lead to losses,” Peter Sleep, a fund manager at Seven Investment Management, told FT. “In 2008 many US investors took cash and put that cash into what appeared to be low-risk bond funds and incurred quite large losses in the financial crisis, whereas European investors sailed serenely on.”
According to Morningstar data, about 30% of ETFs based in Europe lend out securities and almost 71% of US-listed ETFs execute stock lending.
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