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Understanding Securities Lending in ETFs

Lending programs generate fees that can offset some of a fund's operating costs.

Abby Woodham, 03/12/2014

A well-run index fund is typically characterized by its ability to effectively track its index, lagging only by the amount of its expense ratio. In theory, it should not be possible for an index fund to come any closer to its benchmark's return--but some do, including funds that utilize full replication of their index's holdings. A handful of funds even beat their benchmark while perfectly replicating its holdings. How can this be? In many cases, this is an example of securities lending at work.

We'll explain the inner workings of securities lending more fully, but the highly simplified version is this: An exchange-traded fund lends out shares of its holdings to another party and charges a rental fee. Running a securities-lending program is another way for an ETF provider to wring more return out of a fund's holdings. Revenue from these programs is used to offset a fund's expenses, which allows the provider to charge a lower expense ratio and/or tighten the performance gap between an ETF and its benchmark. Active managers sometimes balk at the idea of participating in securities lending because they dislike facilitating another party betting against their holdings. ETFs, however, are (almost entirely) passively managed and have no such qualms. Most large ETF providers run a securities-lending program, because not doing so leaves cash on the table. It's not a risk-free enterprise, however.

Varying Degrees of Success
Some ETFs are able to bring in a surprisingly large amount of revenue through their lending programs. ETFs that hold less-liquid assets, such small caps, international stocks, and deep-value stocks, have the potential to use securities-lending revenue to help offset the costs of running the fund. Some funds are able to use securities lending to recoup a few percentage points of its expense ratio, whereas other funds are able to recover more than 100% of the fund's operating costs. Let's look at three examples.

Among small-cap ETFs, one notable example is Vanguard Small-Cap ETF VB, which charges a 0.10% expense ratio and uses full replication, meaning that it holds all the stocks in its underlying index. Since its inception, VB's annualized performance has beaten its benchmark because of significant securities-lending revenue. Another example is iShares Russell 2000 ETF IWM, which has beaten its index in 2013 and 2012, and has trailed by less than its expense ratio during the last 10 years. In the past year, IWM's securities-lending revenue was greater than its expenses, offsetting its relatively higher 0.24% expense ratio. IWM's 2013 annual report showed that about 14% of the portfolio was out on loan, and that it generated $45.6 million in securities-lending income, which was more than enough to offset the fund's expense ratio.

Funds that track large-cap securities have less opportunity to profit. A report byMarkit shows that last year there was a tremendous supply of large-cap U.S. equities offered for loan, but not significant demand. But further down the market-cap spectrum, demand to borrow rises and supply diminishes. IShares Core S&P 500 ETF IVV, which is allowed to engage in securities lending (unlike SPDR S&P 500 SPY, which is structured as a unit investment trust), generated enough securities-lending income to offset about 13% of the fund's expense ratio--far less than the small-cap ETFs are able to do, but enough to bring its performance even closer to its benchmark's.

How It All Works
There are a handful of reasons one may want to borrow a security, but chief among them is to "short" a stock. Buying a stock on the belief that its price will go up is called a "long" position. Conversely, a "short" position allows an investor to benefit if a stock's price goes down. To short a stock, an investor borrows shares from a provider and sells them. Their hope is that when it comes time to give the stock back to the provider, they will be able to repurchase shares on the market at a lower price and profit from the spread between the prices. Securities lending is an integral part of the process of shorting a stock: For the process to take place, there must be stockholders willing to loan out their shares. Many different entities loan out stock, such as insurance companies, broker-dealers, and pension funds. ETFs (and mutual funds, to a lesser extent) also participate.

Securities lending is usually facilitated by a third-party agent that connects borrowers and lenders and acts like a clearing house for the process. Some fund providers (primarily those with the scale and infrastructure to do so) act as their own securities-lending agent. Securities are loaned for varying lengths of time, ranging from overnight to 30 days to even years-long periods. Borrowers must put up collateral and agree to certain terms. For example, a hedge fund borrowing securities may need to put up 102% (for domestic equities) to 105% (for international) of what is owed. These terms provide compensation for the lenders for the risks they take on. Most securities-lending agents don't accept equities as collateral, so collateral typically takes the form of cash, U.S. Treasuries, or high-rated corporate bonds. The collateral amount is adjusted on a daily basis depending on the fluctuation value of the securities out on loan.

Securities lending actually provides two sources of revenue for ETF providers. First, the fund company can choose to invest its cash collateral or lend out the securities it accepts as collateral. Sometimes the borrower negotiates to receive a cut of the proceeds in the form of an interest rate on the collateral's return, which is called a rebate. Loans of large-cap domestic stock typically incorporate a rebate, but less widely available stocks can command a negative rebate, which is essentially a rental fee the lender collects. This fee is the second way an ETF can generate revenue from loaning its securities.

is an ETF analyst at Morningstar.

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