Most investors may not know about securities lending, a fairly common practice that lets ETF providers offset costs and improve fund performance. And it’s probably just as well: while a significant amount of work goes into the practice, it’s typically much ado about little from the investors’ perspective.
“Funds—and issuers—can make extra cash by lending securities to borrowers, usually short-sellers,” said ETF.com in a recent report. “[T]ypical agreements require the borrower pay a fee to the fund issuer, and also post collateral.”
Collateral can take different forms, including stocks and debt, but most agreements involve cash. ETF issuers typically require at least 102% of market value for US stocks, and 105% for all other securities. Borrowers get the collateral back when they return the securities they borrowed, but until then, ETF issuers can reinvest and gain income from any cash portion.
The US Securities and Exchange Commission (SEC) doesn’t allow ETFs to lend out more than one third of their portfolio’s total market value; most stay well below that limit. According to issuers, securities lending creates enough revenue to help ETFs outperform their expected return by offsetting the drag from a fund’s expense ratio.
But the vast majority of ETFs actually earn back just a small portion of that expense ratio. As an example, BlackRock recently reported that among its iShares ETFs that lent out securities in 2017, 81% made 0.05% of the ETF’s total net assets or less, while 39% made 0.01% or less. According to ETF. Com, the average expense ratio for iShares ETFs is 0.35%.
Muddying the math further is the fact that ETF issuers don’t always handle things in-house. Many pay securities lending agents — usually their fund custodians — to facilitate lending activities and manage borrower collateral.
The benefit investors feel depends a great deal on how much securities lending revenue an issuer is willing to return to the funds. “Most ETF issuers return to the fund 100% of the money made through their securities lending programs,” said ETF.com. “Others retain some portion of those funds for the issuer.”
Major ETF issuers Vanguard, State Street, and BlackRock return anywhere from 75% to 95% of the securities lending revenue their funds make, depending mainly on arrangements they may have with lending agents and other affiliates. In general, a well-run securities lending program creates a meaningful difference in the bottom line of an issuer, and offers a slight benefit to investors.
“[However,] there’s no guarantee a given affiliate in charge of securities lending or managing collateral is the absolute best possible choice from an investor perspective,” ETF.com said. “Ultimately, ETF investors simply have to trust the fund’s board is monitoring and evaluating these relationships for their benefit, not the issuer's.”
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