Fund Selector: Drawbacks of ETF securities lending

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Fund Selector: Drawbacks of ETF securities lending

The prevalence of ETFs has exploded over the past few years. Investors, especially retail investors, have expressed a clear preference for physical replication, where the underlying assets are held directly by the ETF, rather than the synthetic varieties that involve swap arrangements with investment banks. 

This is perhaps understandable in the post financial crisis period, with investors wary about the risks of getting too entangled in more complex investment strategies and favouring simple, straightforward investing. What many investors may not know is that quite a lot of physically replicating ETFs engage in securities lending, whereby the fund assets are lent out for a fee, and that fee is split between the fund and the provider. 

While there is a potential benefit to investors, there is also a form of cost in terms of risk, especially where there is a mismatch between the ETF assets and the collateral posted, not to mention more complexity. There is clearly a judgement call on whether this cost is worth it.

Certain entities may want to borrow assets for a number of reasons, the most obvious being hedge funds that need to borrow securities in order to sell them short. Passive vehicles such as ETFs are natural pools to borrow from, given the stability and predictability of their composition. It should also be noted that the practice can be found in other parts of the market, such as traditional tracker funds, as well as pension and insurance products.

The biggest risk from securities lending is counter-party default, where whoever the assets have been lent to goes bust and is unable to return the assets. Much of this risk is mitigated by the borrower posting collateral to a third party, which the lender gains custody over in the event of the borrower defaulting. Many groups also provide an indemnity against default, and lent assets can typically be recalled within 24 hours.

My concern is that many of these safety mechanisms probably function very well when you don’t need them, but could fail just when they are needed – most likely in extreme market crisis. I wouldn’t have much faith in the indemnity of an investment bank during the depths of a banking crisis. 

The quality of the collateral that is being posted also needs to be considered, and this is effectively a negotiation between the borrower and lender, with behavioural risks such as human greed and complacency.