When ETFs Are Lenders Many funds lend out their holdings to short sellers. Should investors care? By Ari I. Weinberg Updated July 6, 2011
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Resize Most exchange-traded funds are index funds, so their holdings stay relatively constant over time. But that doesn't mean the stocks and other securities owned by ETFs are just sitting there.
Like mutual funds, many ETFs put their holdings to work, lending them out to other investors with the aim of earning a little extra income. The borrowers are typically institutional investors betting that, say, shares of Company A are going to fall in price. These "short sellers" sell the borrowed shares, hoping to buy them back later at a lower price to return to the ETF.
The practice of securities lending affects ETFs in another, more complex way that doesn't occur with conventional mutual funds: Some investors routinely lend the ETF shares themselves to others, typically for short selling.
Obviously, investors benefit if an ETF earns extra income via lending. But international securities regulators have expressed concern that certain lending arrangements could hurt investors or disrupt the financial system. While U.S. regulators have yet to weigh in on the subject, many market observers say that most U.S.-listed ETFs are designed to withstand even the toughest stresses of securities lending.
In a typical transaction, the borrower of a stock posts collateral of 102% to 105% of the shares' value in cash, government securities or a bank letter of credit. If the ETF needs to sell the stock, it can recall it from the borrower. But if the borrower for any reason isn't able to deliver the shares, the ETF is repaid through the collateral instead, although that can have adverse tax consequences for the ETF. The collateral amount is adjusted daily to stay in line with the value of the stock.
The ETF can earn a return on the collateral by investing the cash in, say, a money-market fund. Some of that income is paid to a lending agent. Those fees can vary, but sometimes they can be difficult to find in a fund's annual report.
By law, a fund can have no more than one-third of its total assets in securities on loan. Few ETFs or other funds ever reach that ceiling, and ETFs are considered to be more conservative lenders than other funds.
The income from securities lending can offset some of a fund's operating expenses and thus help a fund more closely track the performance of its benchmark index. At the end of March, for example, BlackRock Inc.'s iShares S&P 500 Index IVV -0.13%decrease; red down pointing triangle fund had $428 million in securities on loan (1.6% of the portfolio) and held $437 million in collateral. Over the fiscal year through March, the ETF netted $1.7 million in lending interest income and fees, enough to offset 7.8% of its expenses. The affiliated lending agent, BlackRock Institutional Trust Co., earned $942,000 in fees over the same period.
The Financial Stability Board, a Switzerland-based international consortium of regulators, flagged securities lending by ETFs as a concern, saying in an April report that thin margins may "create incentives for providers to engage in extensive securities lending in order to boost returns."
One issue is that the shares of ETFs themselves can be redeemed by brokers known as "authorized participants" in return for the underlying shares. The FSB and others, including the Bank for International Settlements and the International Monetary Fund, have expressed concern that such trades could fail if too many or very specific shares are on loan and the ETF is unable to recall them from the borrower. Such a situation might occur if the activity in a stock or the ETF itself caused a rush for redemptions.
The Investment Company Institute, which lobbies on behalf of U.S. fund firms, says the risks associated with securities lending are "far more widespread in other investment vehicles" than in ETFs; others inside and outside the ETF industry agree. In addition, international regulators mostly focused on an ETF structure that is common in Europe but uncommon in the U.S.—one in which the fund gets its market exposure through a derivatives contract, often with an affiliate of the ETF sponsor.
"Securities lending is beneficial to investors when managed appropriately with risk controls and a resolute focus on the fund's overall objective," says Noel Archard, head of product for BlackRock's iShares unit.
Lending ETF Shares ETFs, which trade on exchanges like stocks, are the only investment vehicles that both lend out their portfolio securities and are also themselves actively lent. Investors are increasingly borrowing and shorting ETF shares rather than stocks.
Some ETFs are "net short," meaning there are more shares sold short than shares in existence. That wouldn't happen with a regular stock, which has a fixed number of shares outstanding and thus becomes increasingly expensive to borrow as available inventory shrinks.
But when it comes to ETFs, "comparing shorts outstanding to shares outstanding doesn't always make sense," says Nick Rankin, head of synthetic products and securities lending for Bank of America Merrill Lynch, a unit of Bank of America Corp.
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