When you invest in an exchange-traded fund (ETF), you are buying a basket of assets like stocks or bonds. But behind the scenes, many ETF managers do more than just hold these assets—they put them to work through a practice called securities lending.
Securities lending is a common industry practice that can generate extra income for the fund, which ultimately benefits you as a shareholder. However, it also introduces a unique set of risks that everyday investors should understand.
How Securities Lending Works
In a securities lending arrangement, an ETF temporarily lends some of its underlying stocks or bonds to another financial institution, such as a bank or a hedge fund. The borrower typically needs these shares for various trading strategies, most commonly short selling.
In exchange for borrowing the shares, the institution pays a fee to the ETF. To protect the fund, the borrower must also provide collateral—usually cash or other high-quality securities—that equals or exceeds the value of the loaned assets.
The Boost to ETF Performance
The primary benefit of securities lending is the extra income it generates. For index-tracking ETFs, this revenue is crucial because it helps offset the fund's operating costs, known as the expense ratio.
In some cases, the income from lending can completely cover the expense ratio, allowing the ETF to perfectly match or even slightly beat the performance of its underlying index. Over the long run, even small reductions in net expenses can significantly grow your wealth, a concept you can explore using our compound interest calculator.
Understanding the Risks
While lending out assets is generally safe, it does carry specific risks. As the U.S. Securities and Exchange Commission (SEC) warns investors, engaging in this practice introduces
"the risk of loss of rights in the collateral or delay in recovery of the collateral if the borrower fails to return the securities loaned."
This scenario is known as counterparty risk. There is also collateral reinvestment risk. When a borrower provides cash as collateral, the ETF manager often invests that cash into short-term, low-risk instruments to earn even more yield. If those cash investments lose value, the fund might not have enough money to return the collateral when the borrower gives the shares back.
Safeguards for Everyday Investors
Fortunately, the financial industry employs strict safeguards to protect your investment. The most important protection is over-collateralization. Borrowers are typically required to provide collateral worth 102% to 105% of the borrowed shares. If the borrower defaults, the ETF can simply use the collateral to buy the shares back on the open market.
Additionally, the SEC strictly regulates these activities. The agency requires funds to clearly disclose their lending practices and limits how much of a fund's total assets can be loaned out at any given time—typically capping it at one-third of the total portfolio.
What to Look For Before You Invest
Not all ETF providers handle securities lending the same way. When evaluating a fund, consider checking its prospectus or annual report for two key details:
Revenue Split: How much of the lending income actually goes back into the fund? Some providers return 100% of the profits to shareholders, while others keep a percentage (often 10% to 30%) as a fee for managing the lending program.
Indemnification: Does the ETF provider offer default protection? Some major firms insure the fund against borrower defaults out of their own pockets, adding an extra layer of safety.
Summary
Securities lending is a powerful tool that helps ETFs lower their effective costs and improve tracking performance. While it introduces counterparty and collateral risks, industry safeguards like over-collateralization make it a relatively safe practice. By understanding how your ETF manages these loans and splits the revenue, you can make more informed decisions about where to park your long-term investments.
