Securities lending earnings dwarf fees in some ETFs
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Unusually large securities lending revenues at a clutch of exchange trade funds dwarfed their annual management fees by a factor of five last year.
However, the bonanza may have come as cold comfort to investors, because the strong demand to borrow the ETFs’ stocks was due to the fact they were tumbling in value — leaving investors badly out of pocket in spite of the windfall.
“Investors seeking securities lending revenue face a double-edged sword — maximising lending return often means owning the market’s most-hated stocks,” said Bryan Armour, director of passive strategies research, North America at Morningstar.
Lending out securities held by an ETF — typically to traders such as hedge funds that want to sell the securities in order to short the stocks — has long been seen as a small source of additional revenue for ETFs and mutual funds.
As such, it is often seen as a way to defray some of the annual management fee. Last year, though, some niche US thematic funds received unusually large fees from lending stock.
The ETFs that generated the largest lending revenues were concentrated in the cryptocurrency, cannabis and clean energy sectors.
The $4.5mn Invesco Alerian Galaxy Crypto Economy ETF (SATO) earned a sum equivalent to 3.2 per cent of its assets from securities lending last year, Morningstar found, amounting to 524 per cent of its 61 basis point net expense ratio.
It was followed by the $44mn Global X Cannabis ETF (POTX), with revenues of 2.87 per cent, 562 per cent of its 51bp fee, and the $45mn VanEck Digital Transformation ETF (DAPP), with 2.81 per cent, 561 per cent of its 50bp levy.
Despite this, the trio suffered losses of between 67 per cent and 85 per cent last year.
“Crypto and cannabis were among the worst performing strategies in the market in 2022. Short sellers targeted crypto and cannabis stocks as a result,” Armour said.
“Short sellers have a time limit imposed by the SEC [Securities and Exchange Commission] on how many days they can stay short, so they borrow shares against their short position to circumvent this restriction.
“Fees become substantial when short interest grows, increasing demand while the borrowing supply dwindles. In this case, it led to significant lending returns for these funds,” said Armour.
Overall, Morningstar identified 20 US-listed ETFs that received lending revenues of at least 0.59 per cent of their assets last year, a list heavily skewed to the digital assets and technology sectors that bore the brunt of the market crash.
Only one of the 20 — the $151mn iShares Interest Rate Hedged High Yield Bond ETF (HYGH), the sole fixed income fund on the list — beat the 19.4 per cent decline in the Morningstar US Market Index. HYGH lost just 1 per cent, with its 85bp of lending revenues almost twice its 51bp fee.
Invesco dominated the upper echelons of the list, with five of the top 10 ETFs by lending revenue as a percentage of assets.
“Every fraction of a basis point counts and if we have an opportunity to return some money to our shareholders we will do that,” said Anna Paglia, global head of ETFs and indexed strategies at Invesco, who said it returned more than $100mn to fund investors in lending revenues last year.
Paglia was unsurprised to see several of Invesco’s more “niche” ETFs on the list, given that they often own stocks that can command elevated lending fees, given the balance of supply and demand.
She said Invesco typically had 8 per cent of the holdings of its funds out on loan at any points, compared to just 3 per cent when the lending programme started in 2015.
The lending revenues available to larger, more mainstream funds are usually more modest. The average Vanguard fund received just 2.31bp of revenue last year and the typical BlackRock or iShares fund 2.12bp. Invesco (3.5bp) and State Street Global Advisors (3.43bp) were a little higher, Morningstar found.
Still, given Vanguard’s typically low fees, these revenues offset 16 per cent of the company’s average fee last year, compared to 13.4 per cent for SSGA and 4.2 per cent for Invesco.
Vanguard also scored highly in terms of the proportion of securities lending revenue that is passed to fundholders, rather than being eaten up in lending agent charges.
Vanguard passed 97 per cent of the revenue to its investors in the period from February 2022 to June 2023, ahead of 79.1 per cent for SSGA, 77 per cent for Invesco and 74.5 per cent for BlackRock/iShares, Morningstar found, based on a sample of each sponsor’s funds.
Despite the relatively modest sums typically involved, it said that with other differentiators between funds — such as fees and technology — converging, minor advantages such as lending revenues had become increasingly important.
As for the potential risks, Armour said there had been “some issues” with securities lending during the global financial crisis, predominantly due to “aggressive” reinvestment of cash collateral, rather than the counterparty risk of the borrower.
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As a result, he said regulators had tightened the rules around disclosure, collateral and cash reinvestment, and “securities lending is safer than ever before”.
“There is no such thing as free money. There are always risks associated with stock lending programmes,” said Paglia, adding that reinvestment of cash collateral carried the greatest risk.
Overall, Armour believed that while such revenues were useful to have, investors should not let them influence their overall asset allocation decisions.
“Investors should identify the best type of strategy for them regardless of expected lending revenue. Then they can seek a securities lending edge when looking at a menu of funds offering the same or similar strategies,” he said.