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.
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Abby Woodham does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.