Returns generated from securities lending can offset tracking error and costs of ownership. But how transparent is this activity? Helen Fowler reports
Investors who buy ETFs might be excused for thinking the shares underpinning the product are locked away safely in a vault belonging to whoever issued the fund. Such a belief would be understandable, but mistaken.
The shares are more likely to be on loan elsewhere. Investment firms treat securities like library books, routinely lending them out in an attempt to earn extra fees. ETF issuers are no exception, lending out baskets of stock to firms who need them for trading strategies such as short selling.
Some argue that ETFs are especially well suited to lending stock. Margins are tiny, portfolio turnover is minimal, and providers sit on a large and predictable pile of securities that can be lent to other investors for short selling.
ETFs are a good place to look for borrowers seeking stock. “It’s not like dealing with an actively managed fund,” said Nicholas Thomas, head of specialised sales at HSBC. “There is certainty the holdings will be stable when borrowed.”
Short selling is the practice of selling assets borrowed from a third party with the aim of buying back identical assets at a later date to return to the lender. Hedge funds are among the most prolific short sellers. And, as more of them have turned to ETFs over the past couple of years, demand for borrowing shares has soared.
In return for lending shares, the issuer generates revenue –although it should be noted that often not all the lending fees go to investors, with many providers retaining a large cut for themselves.
Securities lending is most relevant to those firms that favour direct replication of an index, meaning they hold the securities in the index, or a sample of them. Under the alternative approach, indirect or synthetic replication, there are no underlying securities to lend.
When db x-trackers scrapped the 0.15% fee on its DJ Eurostoxx 50 ETF over a year ago, reducing the total expense ratio to 0%, it was able to do so because of revenue from securities lending. Although db x-trackers holds no securities directly, its swap counterpart is Deutsche Bank, which does hold the securities. These can then be lent out.
In the last financial year, investors in the iShares MSCI Turkey ETF received 148 basis points (bps) in extra revenue from stock lending. Anyone who bought the firm’s Dow Jones Eurostoxx 50 fund would have enjoyed a 40bps lending boost. The iShares MSCI World generated an extra 6bps from loans.
Supporters say lending provides easy revenue without serious risk. “Our clients want to generate incremental returns while maintaining a low-risk profile,” said Stefan Kaiser, vice president of global securities lending at BlackRock. “It can help with tracking error and offsetting the cost of ownership.”
Unlike most investment decisions where there is the potential to lose capital, lending returns are usually only positive.
“We are picking up nickels and dimes,” said Richard Genoni, head of the ETF product management business at Vanguard. “It’s a small, incremental benefit, but managed properly it’s low risk. The last thing we want to do is put clients at risk in the hope of picking up a little extra return.”
Lending transactions occur on an ‘open’ basis, meaning either side can cancel the loan agreement with just a few days’ notice. The process can also be flexible. In choppy markets a lender can reduce or cancel loans by asking for their stock back. Agent lending organisations can indemnify firms lending stock against losses.
One important feature of lending activity is that it is always collateralised. To protect against the possibility of a borrower going under, lenders insist on over-collateralisation, which is also known as a ‘haircut’, meaning they take more assets from the borrowers than the securities being lent. The haircut offers a cushion of extra protection against the borrower failing to return the stock.
Practices on over-collateralisation vary widely across the industry and it is worth checking with product providers. iShares typically insists on borrowers handing over 110% to 112% of a loan’s value when lending equities and 108% for government debt. It will alter percentages depending on liquidity, volatility and correlations with other assets.
In the US, lenders typically insist on cash while their stocks are out on loan. In Europe, firms tend to accept non-cash products, such as other stocks or bonds. iShares will not accept more than 40% of the average daily trading volume in any share acting as collateral on a loan, according to Kaiser.
Product providers tend to be conservative in what they will accept as collateral. “We won’t stretch out on the yield curve,” said Vanguard’s Genoni. “We hold mainly short-term high quality instruments, Treasury bills, overnight repos, certificates of deposit.”
HSBC points out that anyone investing in one of its ETFs has the benefit of the balance sheet underpinning the product. HSBC head of ETFs Farley Thomas said its securities lending programme is one of the highest quality because it is backed by an indemnity based on the bank’s robust balance sheet.
The amount of stocks out on loan can also vary from one firm to another and among different products. “We have less than 1% of fund assets out on loan at any time,” said Genoni at US-based Vanguard. Under US law, the firm could lend out as much as a third of its constituents.
Vanguard limits its lending to ensure it retains proxy voting rights needed to protect shareholders’ interests, said Genoni. “We see proxy voting as a duty and securities lending as an opportunity,” he said. “We won’t push lending at the expense of our voting.” Vanguard also limits the lending on any one stock or bond to a certain percentage of the outstanding volume in that security. Genoni added: “We focus on lending the hard-to-borrow securities. We stress value over volume.”
HSBC will not lend more than 75% of a fund and lends that much only if demand is high. “We hold back buffers of 25%,” said the firm’s Thomas. iShares, on the other hand, can lend out up to 95% of the securities constituting its ETFs.
Some ETFs are harder to lend out than others. Different issuers impose different limits on their products. Vanguard will lend out only its most profitable stocks, known as ‘hard-to-borrows’. These are typically less liquid and command a higher borrowing premium.
However, Vanguard stopped all securities lending during the 2008 crisis. “We shut down the programme for four weeks to help stabilise the market even though we recognised the revenue could have been helpful,” said Genoni. “We felt it would have put downwards pressure on prices.” He added: “Some clients would like us to lend more but equally you have clients who want you to lend as little as possible.”
Investors most frequently borrow the underlying shares of an index. They also borrow ETFs themselves. “It’s easy to use an ETF, if you want to go short an index,” said HSBC’s Thomas. “It’s a hugely beneficial tool and we see a great deal of it.”
He said in some ETFs, there is no borrowing of the underlying shares. For example, in certain emerging market ETFs, the shares cannot be physically borrowed because securities lending is not permitted. Thomas added: “But if the ETF is listed on an exchange where lending is permitted, then the ETF shares could be borrowed and sold short.”
Risk and return
As anyone can testify, lending something always involves the risk you may not get it back. “There is a small risk associated with stock lending,” admits HSBC’s Thomas. In the world of finance, this is known as counterparty risk.
The lender is relying on the borrower to return the stock as agreed. For a while it looked as if that could be taken virtually for granted. But then came the credit crisis and the fall of Lehman Brothers in September 2008.
Since the crisis, regulators have taken a greater interest in short selling. Tighter rules on the practice may curb borrowing demand. So too could the move by many European hedge fund managers to launch regulated vehicles.
Securities lending is not quite as innocuous as its practitioners would have us believe. “Securities lending is used broadly across markets and the activity is fairly accepted. What’s not understood is the risk,” said Vanguard’s Genoni.
Lending occurs because other investors need to cover positions incurred while shorting those same stocks. The act of short selling can be enough to depress a security’s price. Some blame stock lending for exacerbating the collapse in bank stocks around the time of the Lehman crisis.
Of course, if short-selling were to cause a stock’s price to fall, the effect would be to erode the value of the ETF. Without lenders prepared to lend out stock, nobody would be able to do short-selling.
However, a threat to securities lending hovers on the horizon. If Europe’s regulators clamp down on short selling, there will be less need for firms to borrow stock.
Splitting lending revenue between issuer and investor is also a tricky area. Firms take different approaches, and it is worth reading the small print in a fund’s prospectus, where issuers should spell out their policy on revenue split.
HSBC has around $500m in ETFs. It alters the revenue split depending on the ETF product in question. “All revenue from stock lending will be disclosed in financial reports,” said Thomas. “We recognise if you are buying a beta product, it has to be competitively priced.” On some funds, the investor might receive as much as 80% of the lending proceeds, with the rest going to HSBC for running the loan programme.
Vanguard credits 100% of lending revenues back to its funds. “That’s a big thing that separates us from other firms,” said Genoni. BlackRock’s iShares applies a 50/50 split between issuer and investor across the board.
Shakespeare famously advised against either borrowing or lending. As one of his characters said: “Neither a borrower nor a lender be.” But today’s investors would probably disagree with the playwright’s advice. Too many are enjoying the low-risk profits of lending out their assets to consider lending an altogether bad thing.
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