Many index mutual funds and exchange-traded funds lend portfolio securities to generate additional income, which can improve these index portfolios’ tracking performance by offsetting fund costs. As investment-management fees among index-tracking funds converge at near-zero levels, securities-lending programs' contribution to performance and potential to differentiate increasingly commoditized funds have come into sharper focus.
Securities-lending income isn’t all gravy—it carries some risk. We believe the benefits of securities lending to fundholders outweigh the risks. A handful of funds lost money from their securities-lending programs during the financial crisis. But securities-lending risk entailed today is less than in the past due to increased regulation.
Overview of securities lending
Lenders of securities generate revenue by charging borrowers a fee. Supply and demand dictate fee levels. In the United States, small-cap and international stocks usually command a higher fee than large-cap U.S. stocks because they are more difficult to locate and borrow in the market. On the demand side, popular shorts command higher borrowing fees.
Lenders require borrowers to post collateral to mitigate default risk. When the borrower posts cash collateral, the lender may earn income by reinvesting the cash. Reinvesting cash collateral too aggressively drove most of the losses from security lending during the financial crisis. To offset the borrower's opportunity cost of investing the cash collateral, the lender may pay a rebate to the borrower. It's helpful to think of the rebate rate as a pricing mechanism.
A typical securities-lending transaction looks like this:
- The lending agent matches a securities lender and borrower.
- The lender delivers the desired security to the borrower.
- The lender collects or pays the rebate rate depending on the difference between the lending rate and funding rate.
- The lending agent reinvests the cash collateral in a money market fund to generate additional income for the fund.
Who gets what?
Most fund sponsors state that 100% of net securities-lending revenue is passed back to the fund. "Net" is the operative word. Securities-lending agents deduct fees from the gross securities-lending revenue figure.
To quantify these fee splits, I compiled the gross and net securities-lending revenue figures from a sample of index mutual funds and ETFs. This sample includes 250 funds and spans offerings from the 10 largest U.S. index fund and ETF sponsors.
The table below lists the fund sponsors' securities-lending agent(s), whether the agent is an affiliate of the asset manager, and the average percentage of gross securities-lending revenue passed to fundholders.
All else equal, sharing a greater portion of the gross securities-lending revenue is a better shake for investors. But it’s hard to make apples-with-apples comparisons across fund sponsors using this metric alone. Some firms with less-generous splits consistently generate more total lending revenue to share.
Key considerations of securities-lending programs
The benefits of securities lending to fundholders outweigh the risks primarily because the biggest risk, losses from cash collateral reinvestment, is lower than it had been in the past. Differences among securities-lending programs tend to move the performance needle less than differences among fees and portfolio construction. But if securities-lending considerations play the role of tie-breaker between two nearly identical funds, keep these three things in mind:
- How favorable is the fee split? All else equal, fundholders stand to benefit more from securities-lending agents that pass along securities-lending revenue to the fund.
- How much securities-lending revenue has the fund generated in the past? Although securities-lending revenue is inconsistent, historical data is the best gauge of how aggressive or conservative the fund's securities-lending program may be. Because of the inconsistency, though, don't bank on a fund sponsor's ability to reliably offset a meaningful portion of fund fees with this revenue.
- How aggressively does the fund sponsor pursue securities-lending income? The preferred approach depends on the investor's risk tolerance. Some fund sponsors lend only opportunistically, putting on loan only securities that command high lending fees. Others lend out a greater portion of the portfolio regardless of lending fee level. More aggressively pursuing securities-lending revenue isn't necessarily riskier given increased regulation.
Please see below for important disclosure.