ETFs’ Hidden Source of Return—Securities Lending

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Paul Romano
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ETFs’ Hidden Source of Return—Securities Lending

Post by Paul Romano » Sat Apr 07, 2018 10:34 am

Interesting Barron's column today:

ETFs’ Hidden Source of Return—Securities Lending

https://www.barrons.com/articles/etfs-h ... 1523054918


A few excerpts from the article:
Consider two ETFs tracking the same benchmark—the $1.3 billion Vanguard Russell 2000 (ticker: VTWO) and the $41 billion iShares Russell 2000 (IWM). Vanguard’s expense ratio is 0.15%, and iShares’, 0.2%, yet over the past five years, iShares has delivered an 11.90% annualized return, compared with Vanguard’s 11.89%. Meanwhile, the Russell 2000 benchmark has underperformed both ETFs with a 11.84% return.



Securities lending largely explains these differences in performance. The iShares ETF had $4.8 billion of its securities on loan, according to its 2017 annual report, and average assets of $31.7 billion during that fiscal year. For that lending, the fund received $68 million in interest. That interest equaled 0.21% of the ETF’s assets—enough to cover its entire expense ratio. Hence, it outperformed the Russell benchmark.


In contrast, the Vanguard ETF had only $25.1 million on loan during its fiscal 2017, on average assets of $1.4 billion. For its loans, it received $1.9 million in interest, which translates to an interest rate of 0.14%. So the iShares ETF’s greater yield allowed it to outpace Vanguard’s fund, despite having a higher expense ratio.

Yet a crucial distinction must be recognized here. Vanguard lent only 2% of its assets, versus iShares’ 15%. That added lending courts added risks.
Still, lending invites conflicts of interest. Unlike Vanguard and Charles Schwab, which return all lending proceeds to their ETF shareholders, BlackRock keeps a portion of ETF lending income for itself, from 20% to 28.5% depending on the fund. Moreover, most ETF managers invest lending collateral in affiliated money-market funds, allowing firms to collect additional fees and creating another incentive to overlend. Of the largest five ETF players, only Schwab invests collateral in nonaffiliated money market funds.

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sunnywindy
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Re: ETFs’ Hidden Source of Return—Securities Lending

Post by sunnywindy » Sat Apr 07, 2018 10:55 am

You can view any ETF's security lending policy using ETF.com's data under the "Efficiency" tab.

Although it does bother me when an ETF issuer doesn't plow all the securities lending money back into the ETF, it's hard to complain when the ETF beats its own index. Also, even though I understand the increased risks of securities lending to the ETF shareholder, I have yet to know of any instances where securities lending has blown up in the issuers face and/or then trickled down to the shareholder. My guess is it will happen sometime (all human endeavors backfire at some point), but my guess is that there will be minimal damage to the shareholders if any at all (maybe someone working for the issuer loses their job, though).
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ThrustVectoring
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Re: ETFs’ Hidden Source of Return—Securities Lending

Post by ThrustVectoring » Sat Apr 07, 2018 8:05 pm

sunnywindy wrote:
Sat Apr 07, 2018 10:55 am
You can view any ETF's security lending policy using ETF.com's data under the "Efficiency" tab.

Although it does bother me when an ETF issuer doesn't plow all the securities lending money back into the ETF, it's hard to complain when the ETF beats its own index. Also, even though I understand the increased risks of securities lending to the ETF shareholder, I have yet to know of any instances where securities lending has blown up in the issuers face and/or then trickled down to the shareholder. My guess is it will happen sometime (all human endeavors backfire at some point), but my guess is that there will be minimal damage to the shareholders if any at all (maybe someone working for the issuer loses their job, though).
The two major risks of securities lending is accidentally waiving the right to reject a tender offer and making your counterparty the person you lent the security to instead of the company that went private. The latter looks something like "you lend out 100 shares, company gets bought at $11.50 per share, lessee closes out their position by sending you $1150, three years later a judge orders the buying company to pay $13.27 per share instead, now you have issues trying to collect the extra $173 from some unknown and hostile party"

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