Securities lending is the process of temporarily loaning securities to a third party in exchange for a fee. Securities are normally lent on an open basis with no fixed maturity date, which gives lenders the flexibility to recall their securities at any time.
In the context of physically-replicated ETFs, lending out a fund’s holdings can help to partially, or in some cases completely, offset management fees and other sources of tracking error. As such, revenues generated from securities lending can be seen as a potential source of alpha.
While mutual funds, pension funds and insurance companies tend to be the biggest lenders of assets, ETFs and other passively-managed funds are also particularly popular among borrowers. This is because they have lower turnover than actively-managed funds and hence are less subject to the risk that the fund manager will recall the loaned securities.
According to a new Morningstar report, nearly 50% of physical replication
ETFs in Europe were engaged in securities lending in 2011.
A Well-Established, Yet Opaque, Practice
Securities lending is widely recognised as playing a vital function in today’s global capital markets by improving market efficiency and liquidity. Yet, being as it is largely carried out over the counter, it remains a rather opaque activity and its true magnitude is difficult to assess. A number of data companies estimate the amount of securities on loan worldwide to be between $1.5 trillion and $3 trillion. According to Markit, there are currently $132 billion worth of equities on loan in Europe.
The lack of transparency within investment funds around securities lending makes it difficult to quantify the benefits of such practices for end investors. Conservative estimates from ISLA suggest that European investors earned €1 billion in securities lending revenues during 2011. Based on our own survey data, we can say that around €40 million in net revenue was generated from this activity in European physical replication ETFs last year with the balance of assets on loan approximating €9.2 billion.
Who’s Borrowing and Why?
Securities lending is rarely undertaken directly between a fund and a borrower. Fund managers usually employ intermediaries, such as custodian banks and third party specialists, as agents to lend their securities for them. These intermediaries benefit from economies of scale, expertise, technology, as well as borrower access which enables them to secure the most competitive pricing. In some cases, the lending agent may be a related party to the fund provider.
Borrowers of securities include large financial institutions, such as investment banks, market makers and broker-dealers. Hedge funds are among the largest borrowers of securities, but they will typically borrow through the prime brokerage arms of investment banks, or broker-dealers, rather than directly from lending agents or fund managers.
These financial institutions borrow securities for a variety of reasons, including ensuring the settlement of trades, as well as to facilitate market making and other trading activities, such as hedging and short selling.
Often associated with hedge funds seeking profit from falling stock prices, short selling has attracted a lot of controversy and bad press since the financial crisis. Regulators around the world have periodically introduced bans on this practice under the belief that short sellers were responsible for pummelling the share prices of certain equities, especially banks. Many academic studies have since concluded
that short-selling bans did little to stop the slide in equity prices and in fact resulted in decreased liquidity, impaired price discovery and wider bid ask spreads.
Also, according to industry data specialist Data Explorers, it is actually rare for lending demand to be driven by fundamental short-selling, i.e. a simple speculative bet that the value of a security will fall, with the borrower hoping to buy it back more cheaply to close out their position at a later date. More commonly, shorts position are taken as part of an arbitrage strategy, such as convertible bond arbitrage, merger arbitrage, etc.
Another arbitrage strategy that doesn’t involve short selling is dividend tax arbitrage, also known as tax optimisation. This is a widespread activity affecting European equity ETFs which can make a significant contribution to the funds’ returns, especially during dividend season. During these periods ETF providers lend stocks that are subject to dividend withholding tax to counterparties located in more tax-efficient jurisdictions. In this way, physical replication ETFs can avoid a portion of the withholding taxes levied on dividends by European countries.
The original version of this article was published in a Morningstar report entitled, "Securities Lending in Physical Replication ETFs: A Review of Providers’ Practices".
