ETF

What you should know about Securities Lending in relation to mutual funds & ETFs

Securities lending is the act of lending securities in a fund to a financial institution to generate additional revenue/return for the fund. Mutual funds and ETFs with huge asset under management (AUM) stands to benefit from securities lending and depending on the fund’s policy, may choose to engage in securities lending.

Typically, funds with small AUM will not engage in securities lending. The reason is that, in the event of a huge redemption, the fund may not have enough securities in the fund to sell to meet the redemption.

Why engage in Securities Lending?

For the past two decades, the cost of investment, i.e. Total Expense Ratio (TER), has been falling quite significantly, due to the intense competition between big-name fund issuers such Blackrock, Vanguard and State Street.

To survive with lower revenue, fund issuers have to come out with new ways to generate additional revenue. This is where securities lending comes in.

Key benefits of Securities Lending

Besides the obvious (generating additional income for the fund), securities lending allows fund issuer to lower its TER, which is good for the investors. With the additional income, fund issuers would be able to channel the additional income back into the fund to offset the cost of managing the fund, ie TER.

This may result in the fund’s GROSS return to equal to the fund’s NET return if you choose the ‘right’ fund. I will elaborate in a separate article as to why securities lending may result in you investing for ‘free’.

Who engages in Securities Lending?

Typically, financial institutions that want to conduct short-selling, would have to borrow securities to short-sell it. Short-selling is the act of selling security (which you currently do not possess) at a ‘high’ price, with the intention of buying back the same security at a lower price at a later date.

Short-sellers conduct this operation because they believe/speculate that the price of the shorted security will go down in the future. If it does, they will make money. Obviously, if the price goes up in the future, the short seller loses money since they will be buying back the stock at a price higher than they have sold for at the start.

Apparently, some of the biggest companies in the world, Google, Amazon and the likes, are hot favourites among short-sellers. Not sure if it is a good idea to short some of the most innovative companies in the world. But hey, who knows?

For more information, see https://www.investopedia.com/news/10-biggest-shorts-us-equity-market-short-selling/

In general, you are looking at Vanguard, Blackrock and State Street at the opposite side of the securities lending trade, acting as the lender, since some of the largest ETFs in the world comes from these issuers.

How the process works

The borrower will request to the lender to borrow a particular security. The lender will loan the said security on conditions that the borrower will pay the lender a fee and provide collateral (typically short-term government treasuries). Usually, the collateral’s value will be at least equal to the market value of the loaned securities.

Once the collateral is received, the lender will deliver the securities to the borrower. If the agreed collateral is of cash nature, the lender would then invest the collateral into a money market fund to generate further additional income. If the loaned security pays out dividends during the loan term, the borrower would need to pay the dividends back to the lender.

The above diagram depicting the process is assuming that the agreed collateral is cash and not government treasuries.

At the end of the loan term, the borrower has two choices. Either, rollover the existing term (essentially extending the loan term) which may come with new conditions, or terminate the loan term.

In the event of termination, the borrower would need to give back the loaned security to the lender. The lender would release the collateral back to the borrower. Everyone wins in this scenario and everyone is happy.

Now imagine if the borrower default, i.e. fail to return the loan security. Securities lending does come with its own set of risk. See below for more information.

Associated risks with Securities Lending

Borrower’s default risk

One of the key risks in securities lending is the risk of the borrower not returning the loaned securities promptly if at all, at the end of the loan term. To mitigate this risk, all lenders/fund issuers would conduct risk assessments on all borrowers regularly.

If there are any red flags on the borrowers, lenders would typically refrain from lending securities to the borrowers.

Collateral reinvestment risk

When the lender invests the cash collateral received from the borrowers into a money market fund, the objectives are to preserve principal and liquidity while generating income.

Principal preservation is the act of ensuring that the principal amount will not be eroded at the end of the investment term. For example, if you invest $100 at the start, you expecting to receive back at least $100 at the end of the investment term.

Money market funds are low-risk investments that have a very high probability of preserving your capital at the end of the investment term.

However, reinvesting the cash in the market exposes the lender to various investment risk such as credit, liquidity, market risk, etc. To mitigate this risk, the lender would usually invest in high quality, short-term securities that fulfil certain requirements with regards to credit quality/rating, maturity and liquidity.

Typically, most lenders would have restriction on the percentage of the fund’s asset that can be loan out to borrowers.

Conclusion

Now that you have a fairly good idea behind securities lending operation, the last step would be to find out if your investment fund is conducting such operation. After all, it does not hurt to know and it makes you a more informed investor.

To know if your investment fund/fund house is conducting such operation, simply google the name of the fund house along with the following sentence; “securities lending“. Typically, most fund houses that conduct such operation would have internal policies regarding securities lending and from the Google search results, you should have a fair idea if the fund house conducts securities lending. Most major fund houses are transparent with their securities lending operation.

If you are investing in US-listed ETFs, simply go to ETF.COM < https://www.etf.com >, search using your ETF ticker, scroll to the bottom and look for the FUND STRUCTURE section. See the screenshot below for an example, I’m using VOO ETF (Vanguard S&P 500 ETF) as an illustration.

If the “Securities Lending Active” is a “Yes“, it means that the fund conducts securities lending. Under the “Securities Lending Split (Fund/Issuer)“, it displays respectively the percentage split of the revenue between the fund and the issuer, from the securities lending program. For the above example, the fund would receive 100% of the revenue from the securities lending program. In other words, investors of VOO ETF would receive the full benefit of this program.

For more information on VOO, see https://www.etf.com/VOO#overview

As always, take personal responsibility of your financial well-being and do your own due diligence.

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