Understanding Securities Lending in ETFs

Securities lending is a little talked about but important aspect of exchange-traded fund management. Index-tracking ETFs leave few chances for management teams to carve out an edge over their benchmark. Securities lending is one of those chances.

What Is Securities Lending and How Does It Work?

The practice entails an ETF lending out portfolio securities (like stocks or bonds) to an interested party and collecting a tidy fee in the process. Borrowers include broker/dealers and hedge funds, which usually borrow securities to avoid settlement failure when short or to take advantage of arbitrage opportunities. Lending agents take a cut of revenue in exchange for matching the lender and borrower. It’s a common practice that can help recoup an ETF’s management fee and give the returns a nudge.

To protect the lender from risk of loss, lent securities are always collateralized using cash or securities, commonly government debt. Cash collateral is more common in the United States, while Europe tends to favor noncash. This article will focus on cash collateral scenarios for simplicity. In either case, the revenue received by the lender is dependent on the demand value of the security on offer.

Exhibit 1 shows a securities lending transaction with cash collateral. To compensate the borrower for interest on posted cash collateral, a rebate is paid to the borrower at a rate negotiated by both parties. The rebate rate is the lender’s lever for generating income. It’s determined by the demand value of the stock or bond on loan. Securities in high demand are usually stocks or bonds of typically small, illiquid, or otherwise unpopular companies. The higher demand for these stocks or bonds means the lender can negotiate more favorable terms on the loan, allowing them to lower the rebate rate and maximize the demand value and thus securities lending income. The breakdown of securities lending income is shown in Exhibit 2 below.

The overnight bank funding rate, or OBFR, represents the yield the lender can receive by investing the cash collateral in a risk-free instrument. A demand value of 1.25% is considerable and suggests the security on loan is in high demand.

The demand value is essentially the fee paid by the borrower to the lender. Securities with a high demand value are commonly referred to as “on-special” or “hard-to-borrow.” By offering securities in high demand, the lender can negotiate a much lower rebate rate than the OBFR, earning a higher profit. A liquid security with less demand would require a higher rebate rate, pinching the demand value. In some cases, the demand value can be close to zero, or potentially negative.

Reinvestment return is the yield on top of the risk-free rate that the reinvested cash earns. The breadth of acceptable reinvestment choices is narrow, but some low-risk vehicles offer slightly better yields than the OBFR. (In 2010, the SEC mandated tighter quality, duration, and liquidity requirements for securities eligible for investment by money market funds.)

Any yield greater than the rebate rate (demand value plus reinvestment return) is the income earned by the ETF company. Lending agents get a piece of the action, too, usually collecting a fee of between 10% and 50% of that earned income. This is the negotiated fee split noted in Exhibit 1.

What Are the Risks in Securities Lending?

For on-specials, the appeal of securities lending to an ETF provider is clear. Meaningful income can be collected by running a successful program. However, it is not a riskless endeavor.

The risk of loss from securities lending is minimal. Even still, there are two principal risks an ETF company assumes by operating a securities lending program. These risks include:

1) Counterparty risk—risk the short seller can’t repay the collateral.

2) Reinvestment risk—risk the reinvested cash loses value.

Counterparty risk is generally negligible. In many lending agreements, the lending agent provides indemnification if the borrower goes defunct. The borrower is typically required to overcollateralize the loan—usually in the range of 102% to 105% the value of lent securities. As a final precaution, the loans are callable, which means the lender can call back the securities at any time.

Protections to mitigate counterparty risk make reinvestment risk an ETF company’s primary concern. Cash reinvestment vehicles are usually ultralow risk, but they can lose money from time to time. For example, during the 2008 financial crisis, a number of index mutual funds and ETFs incurred a securities lending loss, causing the funds to lag their benchmark by much more than anticipated. Some firms are conservative in how they reinvest cash collateral, opting to only match the OBFR using liquid reserve funds. Other firms are more aggressive, electing to invest in safe, but comparatively riskier, term repurchase agreements or similar vehicles to enhance yield.

Operational risk is also present, but assuming sound due diligence and organizational processes, ETF providers should rarely enter into agreements where the operational cost of lending exceeds the earned income of the program.

What Are the Benefits?

Effective securities lending programs can recoup some or, less often, all of an ETF’s fee. An investor should expect a fund that charges 0.10% to trail its benchmark by the same amount annually. Securities lending can reduce tracking difference incrementally. Some ETFs even outperform their benchmark thanks to high securities lending income. Exhibit 3 shows the 10 U.S.-domiciled ETFs that were most successful at offsetting their respective fee through securities lending in 2022.

Strategy risk always overshadows securities lending returns, though. ETFs that boast the highest securities lending returns hold some of the market’s most unloved companies and can falter because of it. Global X Cannabis ETF POTX earned a 2.87% return through securities lending in 2022, which was the highest securities lending return out of the roughly 3,200 U.S. ETFs in Morningstar’s database. POTX charges 0.51%, so its securities lending return boosted overall performance by more than 2 percentage points versus its index.

High securities lending returns are eye-catching, but no amount of lending revenue will offset risk inherent to the underlying strategy. Despite a highly successful lending program, POTX’s portfolio of unprofitable and heavily shorted stocks still fell by 67% in a gruesome 2022 for markets. The Morningstar US Market Index lost 19% on the year.

Companies like Vanguard and Schwab pair more-sensible strategies with a more conservative approach to securities lending than the likes of Global X, which lent 26% of POTX’s portfolio on the year. (The SEC limits the percentage of securities on loan to one third of fund assets.) But by charging a lower fee, it is just as successful at offsetting fees as the niche strategies that populate most of Exhibit 3. Vanguard Extended Market ETF VXF generated a much lower 0.15% securities lending return in 2022 by lending out just 2% of the portfolio. Because of its lower expense ratio, it fully offset its fee and generated 9 basis points of extra performance. For the year, VXF beat its benchmark by 8 basis points but still fell 26%.

Morningstar Direct users have some tools to analyze participation and success rates of ETF securities lending programs. Six relevant data points, shown in the table below, can be used as search criteria. Information embedded in these data points is subject to verification through the appropriate SEC filings.

Proceed With Caution

Securities lending plays a small role in ETF management, but it’s a useful tool for offsetting fund expenses. ETF providers use differing approaches, but most are effective at offsetting at least some of their respective expense ratio.

Broad-market ETFs from firms like Vanguard and Schwab are usually conservative in their securities lending approach. Meanwhile, more niche—and potentially risker—strategies from Global X and Invesco take a more aggressive approach, attempting to capture as much of their holdings’ demand return potential as possible. Both are successful in their practice, but the underlying strategy will always drive return and risk.

In short, securities lending is helpful but not enough to make a bad fund good. Hard-to-borrow securities tend to be those that the market expects to do the worst. Investors should be cautious about owning them.

Interested readers can find our 2018 full-length report on this topic here.