By Abby Woodham
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 (NYSEARCA: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 (NYSEARCA: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 by Markit 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 (NYSEARCA:IVV), which is allowed to engage in securities lending (unlike SPDR S&P 500 (NYSEARCA: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.
ETFs don't necessarily keep all the proceeds from securities-lending programs. Various fund providers take their cut of the revenue, and the split can vary. Vanguard returns all profit back to its funds after fees. IShares takes 20% to 30% of revenue (recently lowered from 35%), and State Street takes 15%.
Not Without Its Risks
To avoid losses, most ETF securities-lending programs operate very conservatively, only investing collateral in money market funds or other short-duration, low-risk assets. Many ETF providers completely eschew volume lending, which is the act of loaning out large amounts of low-fee-generating common securities and making up ground by investing the collateral in risky assets. Additionally, some fund providers indemnify their ETFs against any losses that might arise from share lending.
But securities lending is not risk-free, even with the 2%-5% additional buffer required of collateral. If an ETF invests its collateral in overly risky instruments, the fund (and ultimately its investors) is responsible for covering any shortfall in returning the borrower's collateral. In this case, the risks assumed by the ETF provider and the ETF's investors are asymmetric: The provider is not liable for losses, but is free to gamble with the shares and take a cut of any profits. As a GAO report on securities lending pointed out, this arrangement gives incentive to securities-lending programs to invest collateral in an overly aggressive manner.
Loaned shares are also subject to the possibility of counterparty risk, or the risk that the borrower won't follow through with its obligation to return shares. Almost all ETF providers disclose very minimal information about their programs, which means investors could be taking on more risk in their portfolio than meets the eye. There are several cases of fund providers being sued by investors for not sufficiently disclosing risks and then losing money. A notable example was Lehman's bankruptcy, which meant entities that loaned securities to Lehman never saw their holdings again.
Mining for Data
There are a handful of ways to get more information on the securities-lending practices of the ETFs in your portfolio. If you notice that your ETF (which is employing full replication) lags its benchmark by less than its expense ratio, it may be an indication that the fund is engaged in securities lending. Morningstar also publishes a calculation called the "estimated holding cost" that directly measures the performance of a fund relative to its benchmark over the past year. There's a good chance that an ETF with an estimated holding cost that is lower than its expense ratio is also engaged in securities lending.
The best source of raw information on securities lending is an ETF's annual report, which can be found on the provider's website or in the "Filings" section of the ETF's page on Morningstar.com. In the ETF's statement of operations, investors can find the investment income generated by securities on loan, as well as the total expenses of the fund. In the fund's assets and liabilities statement, the amount of collateral the fund has invested for loaned securities can be found. Most providers also state the dollar value of the securities on loan.
Hunting for Disclosure
Even with some data available in a fund's annual report, the transparency of securities-lending programs leaves much to be desired. Investors should be armed with the knowledge of the risks and rewards they are taking on behind the scenes; as the industry stands today, this vital information is not made readily available. We'd like fund providers to disclose more information on their securities-lending programs. Ideally, investors should have easy access to a variety of data points that let them make informed decisions about which ETFs to invest in.
First on the wishlist is disclosure on the way the fund provider splits share-lending revenue, and whether the ETF is indemnified from losses. Some fund companies, like Vanguard (which returns 100% of share-lending revenue to funds after costs), are forthcoming with this information. Other fund providers have materials detailing their share-lending program but don't state the revenue split in an obvious place on those materials, their website, or the fund's prospectus. It takes a call to the provider to find out, and that's no good.
We'd also like fund providers to provide data on what percentage of a fund's assets is loaned out at the present moment, as well as the 12-month historical average. Investors should be able to find out how much of their fund is loaned out.
Finally, companies should publish the monthly or quarterly revenue each fund generates. Not only would this measure be friendly to investors, such transparency could serve as a net positive for fund companies whose lending programs meaningfully offset the expense ratio of their ETFs.
Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.