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When you consider an Exchange Traded Fund (ETF), it’s important to take account of securities lending. ETFs that engage in prudent securities lending can reduce the burden of investment management fees and enhance your returns. Remarkably, some low fee ETFs can beat their benchmarks because of securities lending policies . This essentially makes them free to own. Of course, this isn't true for all ETFs, but some that hold stocks that are hard to borrow and hence attract higher lending fees can do well.
I previously wrote about some research that showed how certain active funds are behaving more like index trackers, but the reverse is also occurring, with securities lending. Some index trackers are managing to beat the indices they track, just as active funds aspire to do. In fact, some ETFs such as the Vanguard Small Cap ETF (VB) has done so over a period of many years.
It's important to understand how ETFs and securities lending work. An Exchange Traded Fund or ETF is, in essence, a stock that encompasses a group of assets. An ETF can include a group of bonds or stocks designed to meet an investment objective, or track an index. Although an ETF encompasses a group of assets, it acts like a single stock and is bought, sold, and traded on the stock market. This means that its total value fluctuates daily on an exchange.
Securities lending for an ETF works in the following way. Your ETF agrees to lend a specific stock to a third party in exchange for collateral, the ETF provider receives a fee in return for lending the stock and can also earn a return on the collateral it holds while the stock is lent. There are two main risks involved. Firstly, that the third party fails to return the stock, and secondly that the collateral against the loan falls in value. Both risks can be managed by an effective trading desk. And, if you're wondering about the motivation of the third party in the transaction, they are likely a short seller, hoping the stock will fall in value, so that the stock they return to close out the transaction is worth less than at the time they borrowed it.
The amount of securities lending profits that ETF sponsors pass onto ETF investors varies, but appears to be increasing. Blackrock was the subject of a lawsuit contesting their return of securities lending fees to investors, that case was dismissed last year. As of the start of this year Blackrock (the owner of iShares) returns 70%-75% of securities lending revenue to investors. Vanguard returns 100% of securities lending proceeds to investors after their costs. As Dave Nadig of ETF.com argues the difference isn't just in the revenue/profit split which is calculated in a slightly different way by the different firms, it's also in the policies for lending, Blackrock appears to lend more broadly, hence increasing potential lending returns, but also raising the risk level slightly, whereas Vanguard may be more selective in identifying lending opportunities with greater profitability.
So, what are some of the funds that benefit most from securities lending? As I mentioned previously, The Vanguard Small Cap ETF (VB) has historically eliminated its costs with securities lending, and is a constituent of many FutureAdvisor customer portfolios, the Vanguard Small Cap Growth ETF (VBK) has outperformed its benchmark on a 10 year view, but not over the past year. iShares Russell 2000 ETF (IWM) along with the growth tilted variant (IWO) has beaten its benchmark for the last three calendar years, though interestingly the value tilted sibling (IWN) has not. Turning to
It is important to note that the benefit of securities lending does not appear to carry over to active mutual funds, though a majority do engage in the practise. A recent working paper by Evans, Ferreira and Prado concludes that active funds which engage in securities lending tend to underperform similar funds by a significant amount. This may be be due to selection effects, since the securities which attract significant lending fees are more likely to fall in price. The authors imply that these stocks should be sold, rather than lent. However, this is not an issue for index funds that are tracking a defined benchmark and hence have no stock selection decisions to make.
As with everything in life, just because something is free doesn't necessarily mean you need to have it. There is some minor risk involved in lending activities. In future, changes in the fees for securities lending, or many other factors could impact these ETFs. Nonetheless, you are looking at gaining small capitalization exposure in your portfolio, consider an ETF that is both low cost and engages in securities lending as a potential way to enhance your returns.
The views expressed represent the opinion of the author and are not intended to reflect those of FutureAdvisor or serve as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell securities. Past performance is not indicative of future results.
