In the world of exchange-traded funds (ETFs), securities lending is a simple process that can generate significantly higher returns for investors. Of course, the ‘lending’ aspect of any investment portfolio generates significantly higher risk than otherwise would be the case.
The growth of ETFs has reached epic proportions, as more investors flood the market on the hope of earning income that is above and beyond conventional equity markets. This has led more investors to pursue ETFs that practice securities lending.
The logic is fairly straightforward: an equity-based ETF will typically contain thousands of shares of various stocks. If there is a short-seller who is willing to borrow these stocks and is willing to post collateral for doing so, it makes sense to lend them out for higher returns. This strategy has been employed successfully in the past and remains a go-to method for investors seeking tighter index tracking and more lucrative returns.
That being said, ETF securities lending has its fair share of controversy, mostly emanating from the debate over ‘inside’ and ‘outside’ lending. Inside lending refers to the lending of underlying securities whereby ETF issuers dole out the fund’s underlying assets for the benefit of all investors. Outside lending is the lending of ETF units through a lending agent.
Securities lending is also far riskier than conventional buy and hold investment strategies. One of the biggest risk in securities lending stems from the short-seller – namely, if they go bankrupt. Fortunately, standard practice prevents borrowers from taking more than they are worth. One way to avoid a potentially bankrupt borrower is to force them to provide collateral that exceeds the value of the loaned securities. This is exactly what securities lending guidelines do.
The real risk stems from what the issuer does with the collateral they receive. Will they sit on it or put it back into the market for extra interest payments? This is where securities lending practices go sour, as we saw with Lehman Brothers during the 2009 financial crisis.
But Is It Profitable?
As is the case with any investing strategy, success depends on several factors. Securities lending programs have proven successful in the past, especially among ETFs that hold in-demand securities. These funds can earn a significantly higher premium lending out their holdings. It isn’t terribly uncommon for some securities lending ETFs to pay yields as high as 7% even though none of their underlying holdings pay dividends. This means the ETF is generating enough revenue from securities lending to pay a handsome dividend.
The Bottom Line
Securities lending is an attractive option for funds holding high-quality, in-demand stocks. However, executing the strategy profitably takes a little more finessing. That being said, there are at least a few funds doing it right. Investors seeking greater returns at a slightly higher risk might find it useful to focus on these funds.