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Stock lending with ETFs – is it dangerous? – columns

In this post, we’ll look at the stock lending that occurs in most ETFs. The presentations and assessments in the financial media of securities lending for ETFs often contain serious errors.

The topic of securities lending pops up with regularity in the financial media and in financial blogs in connection with the alleged structural risks of ETFs. Because the statements about securities lending in these publications are often superficial and sometimes contain downright hair-raising errors, we submit the matter Securities lending with ETFs in this post a fact-based consideration. We address the eight most important questions and facts about securities lending.

(1) What is stock lending? How does it work?

Securities lending (“WPL”) has been a global practice among institutional investors for decades. It is tightly regulated under supervisory law, represents a highly standardized process and makes an often overlooked “silent contribution” to the functioning of the international securities markets.

Stock lending typically works like this: The owner of a security (e.g. an actively managed mutual fund, an ETF, or a sovereign wealth fund like the Norwegian Oil Fund) lends a security (a stock or a bond) to you for a limited period of time Borrower. The borrower is another institutional investor, such as a hedge fund. The borrower pays the lender (the ETF) a loan fee at the end of the loan period, e.g. B. 0.1% of the value of the loan item per annum (one 365th of 0.1% per day). Usually the loan period is only a few days. During the loan period, the borrower provides the lender with collateral, e.g. B. Cash or highly liquid securities such as short-term government bonds from western countries with high credit ratings.

In the EU, the value of the collateral for investment funds for private investors (“UCITS funds”), including ETFs, must be at least 105% or 110% of the value of the loaned item. Overcollateralization is therefore legally required. Almost without exception, the collateral is more stable (less volatile) than the loan. Both the value of the loaned item and the value of the collateral are automatically checked once a day. Should the collateralization ratio (the “Loan to Value”) fall below the above If the minimum quota falls, the borrower must provide additional collateral at the beginning of the next day, i.e. top up the collateral or return part of the loaned item. Because the collateral is less volatile than the loan, the extent of the overcollateralisation usually increases within one day in the event of negative market trends (which are “generally disadvantageous” for ETF investors). That should be seen as positive by ETF investors.

The WPL fees of a certain security (the WPL income from the point of view of an ETF that practices WPL) tend to be higher the more illiquid the security is, the less frequently it is traded and the more short-selling in general for the security take place. Short-selling is the main reason for WPL on the borrower side. More on short selling below in section 3.

The lender is thus doubly protected. Firstly, the borrower is directly liable with his entire assets for the return of the loaned item and, secondly, the lender has direct access to the collateral, which is very likely to be worth the same or more than the loaned item at any time. There are a large number of other procedural and logistical security features prescribed by supervisory law, which we cannot go into in detail here for reasons of space, e.g. B. what types of securities are permitted as collateral, what is the maximum proportion of the loaned securities at a given point in time, or who is allowed to act as an account or custodian at which collateral is deposited.

If dividends or interest payments are made on the loaned security during the loan period, these will flow to the lender (the ETF). To whom any current income (interest, dividends) from the collateral provided by the borrower will flow, is agreed on a case-by-case basis.

Any voting rights – if there is a shareholders’ meeting during the loan period for a share – can normally be exercised by the person who is the owner of the share at that moment. Logically, this is not the lender, but in most cases it is not the borrower either, but another, third party. The details on this are explained in section 6 below.

(2) Who practices securities lending?

The short answer to this question is: “All” means that basically all types of institutional investors practice WPL: actively managed mutual funds, ETFs, hedge funds, state pension funds (the largest fund segment in the world), sovereign wealth funds , other types of institutional funds, banks, insurance companies – all of them. In other words, the participants in the WPL market are the largest and most professional financial investors on the planet.

It is a curiosity that “critical discussions” about WPL focus almost invariably on WPL in ETFs. Why WPL for other fund types that are more important in terms of investment volume, e.g. B. actively managed investment funds or pension funds, private investors and “critical journalists” does not seem to be of interest, probably only the gods know.

(3) Why is stock lending done?

As already indicated in the answer to question 1, the owner of a security for which there is a demand for borrowing can achieve additional income through WPL in addition to the conventional market return of the security (interest, dividends, price gains). From the point of view of the investors in an ETF, it is the task of the ETF provider (the person who offers and manages the ETF) within the framework of law and statute as well as the requirements of the fund prospectus to maximize the return for the investor and not to waste potential sources of return let, speak to waste. In a figurative sense one could argue that just as one does not simply throw away useful, usable food and other resources in a sensible private household, in an “ETF household” the WPL source of income is not “thrown away”.

If you consider that private investors in ETFs (rightly) prefer an ETF A when buying an otherwise identical ETF B if the Tracking difference of A by 0.1% p.a. is better than that of B, then it should come as no surprise that the provider of ETF A uses WPL, because this controls an average of about 0.1% p.a. and in some cases more to the total return of the ETF. (The tracking difference is the difference between the return of the ETF and the return of the securities index it tracks, which, unlike the ETF, is known to contain no operating costs. The tracking difference is often given for a period of one year or as an annualized number. )

(4) The benefits and risks of stock lending

The benefits of WPL are easy to explain: WPL improves the total return of an ETF for investors compared to the alternative scenario “foregoing WPL”. How high this contribution to the return is naturally depends on the individual case. It is usually around 0.1% p.a. and in rare individual cases 1.0% p.a. exceed. We can conclude that this WPL remuneration is “fair” from the fact that it comes about in a global, liquid, well-regulated, functioning market between large professional investors.

Many private investors mistakenly believe that it matters to whom the WPL income goes – to the ETF provider or the ETF itself. Here we are dealing with an economic mistake, the confusion of a superficial, formalistic aspect with the really relevant fundamental one Overall context. To illustrate: The two stock ETFs X and Y map the same index and both operate WPL. With ETF X, all WPL earnings flow to the ETF (i.e. directly to the investor’s assets), but only 60% with ETF Y. The other 40% go to the ETF provider. Is this why ETF X is preferable? Answer: No. Assuming the two ETFs are identical in every other respect, then the one with the better tracking difference or the higher return – and that can also be Y – is to be preferred. In contrast, the distribution ratio for the WPL income is irrelevant in and of itself. Why? In the case of ETF Y, the ETF provider could use said 40% of the WPL income to lower the management fee in return or to finance other operational benefits for the ETF. If it does, then the “WPL distribution mode” in isolation would be potentially a misleading decision criterion. As a result, Y can in any case be the ETF that is more profitable for investors, even though a smaller part of the WPL proceeds directly benefits the investors.

In this context, it should also be taken into account that the “running costs” (the Total expense ratio / TER) of an ETF any cost-reducing income from WPL for regulatory purposes Not be allowed to take into account, which further complicates the issue.

Ergo: Investors are badly advised if they use the allocation quota in the WPL as an ETF selection criterion.

Now for the risk from WPL. From the point of view of a private investor in an ETF, damage from WPL transactions for an ETF could occur if the following three risks arise at the same time materialize:

(a) Within a individual On the day, the market values ​​of the loaned item and the collateral develop in such a way that the overcollateralisation rate (see section 1) is not reached. Statistically, this case is rather rare. In the vast majority of cases, this only happens if the value of the loan item increases sharply on the day in question.

(b) There is a decrease in the Loan to value ratio below 100% and At the end of this one day, the borrower is economically unable to compensate for the difference from his general economic resources (additional collateral). This inability is unlikely because the lender subjects the borrower to a credit check before entering into the WPL business, and because WPL businesses generally have very short terms.

(c) The ETF provider is not willing and able to step in voluntarily in the event of a loss that arises despite the specific collateral and despite access to the general assets of the borrower. That he would do this voluntarily can be assumed because the long-term reputational damage from a refusal would outweigh the short-term economic benefit of the refusal. In fact, some ETF providers have made limited commitments to step in (pay) in such cases, even though they would not be required to do so under regulatory law.

The fact that these arguments to explain the very low risk of WPL are not just gray theory is clarified in section 5 below.

(5) The history of stock lending

WPL in the modern form described here has existed for over 50 years. During this long time, the WPL process has become more and more efficient and robust, and its state regulation in the world’s major capital markets has become more and more granular, modern and strict.

In the case of investment funds sold to private investors (so-called “UCITS funds” in the EU and “mutual funds” in North America), as far as we know, there has not been a single (!) Case worldwide in these five decades in which a private investor from WPL suffered economic damage suffered. This flawless balance sheet is offset by 50 years of benefits, i.e. additional returns from WPL for the investor community. Such an impressive track record is very rare in the financial sector in general, and in financial products in particular.

It should be noted that five severe “stress tests” have taken place on the global stock market in this half century. UCITS funds / ETFs, the clear majority of which operate WPLs (see figures below), passed all five tests with flying colors from a legal point of view: the oil crisis crash in 1972/73, the short-term crash in October 1987 with a one-day loss in stock market history of over 20%, the Dotcom Crash 2000-2002, the Great Financial Crisis 2008/2009 and the Corona Crash in early 2020.

(6) Why does securities lending have a bad reputation with some investors?

The vast majority of borrowers at WPL are hedge funds that need a stock to sell short. A short seller speculates on a short-term falling share price. In order to sell a stock short (to “short”) it must first be owned. For decades the mechanics of short selling has been deluded by the false claim that a short seller is selling something that he does not own. In reality, the short seller owns the stock at the moment of the sale, otherwise a normal buyer would not even get involved in the trade for obvious reasons. Before selling, the short seller acquires civil law possession (ownership) of the share via the loan deal. (“Naked Short Selling” is actually a sale without prior ownership, but naked short selling is prohibited in most states, would be a rare exception even without that ban, and does not affect ETFs either way.)

At the end of the lending period (e.g. after two weeks) the short seller buys the share on the open market and then returns it to the lender. If the stock price at that moment is lower than when the short sale started (and the start of the loan period), the short seller has made money.

Short selling has existed for over 400 years. Not only is it an age-old phenomenon, but professionals also agree that short selling is a necessary part of a healthy capital markets ecosystem. Short selling contributes to the information efficiency of markets and to market hygiene by helping to bring overvalued, overpriced securities to a more realistic, sustainable value and by – figuratively speaking – incompetent or wasteful board members “scaled down” to their appropriate size. In countless cases, short sellers were the “heroes” who, earlier or more decisively than supervisory authorities, public prosecutors and courts, helped to uncover and punish fraudulent activities in companies – most recently in the Wirecard case.

There is no doubt in the scientific literature about the economic benefits of short selling. Supervisory authorities and central banks also see this in their fundamental investigations, e. B. the most important authority for securities trading in the EU, ESMA (European Securities and Markets Authority) and the Bundesbank.

Still to the open question from item 1: Who exercises a voting right if there is a shareholders’ meeting during the loan period? This is the one who bought the stock from the short seller and is now the owner. If the lender (the ETF) does not want to lose its voting rights, it must either refrain from lending the share within this short period (typically one day per year) or include a corresponding “loan recall provision” in the WPL contract . Both often happen.

(7) The regulation of securities lending

In the EU, WPL, insofar as it is implemented by UCITS funds (including ETFs), is based on the EU’s “Securities Financing Transactions Regulation” (SFTR). This body of law regulates the essential risk-relevant aspects of WPL. At the beginning of 2020, the SFTR brought a further tightening of the previously applicable WPL regulations. The above-mentioned ESMA and other semi-governmental financial market bodies have published several separate guideline papers, some of which are binding and some of which are recommendations, on the practical implementation of the SFTR by market participants. Similar WPL regulations exist in the USA. Overall, WPL is a comprehensively and strictly regulated type of financial market transaction.

(8) What is the proportion of WPL ETFs?

In early December 2020 were on the website www.extraETF.de 1,788 ETFs listed, i.e. ETFs that their providers intend to sell to private investors in German-speaking countries (there are currently around 7,000 ETFs worldwide).

Some of these 1,788 ETFs are excluded from the “WPL candidate universe” for objective reasons, including ETFs that track non-securities index underlyings (e.g. commodities, precious metals, cryptocurrencies or hedge fund indices) , and almost all swap ETFs (“synthetic” ETFs). In principle, WPL would be conceivable for swap ETFs, but it is almost never worth it financially. The reasons for this are not explained here for reasons of space.

If WPL is not worthwhile for an ETF, then it is rational for the ETF provider WPL to contractually (“officially”) exclude it in the fund prospectus from the outset, because it addresses the minority of “WPL opponents” among all private investors without asking for it having to make an economic sacrifice. He wouldn’t have practiced WPL anyway, even if it had been allowed.

Of the 799 physically replicating equity ETFs (the non-swap equity ETFs), 749 were approved for WPL in December 2020 according to www.extraETF.de. That’s 94%. Of the 357 physically replicating bond ETFs, 180 were approved for WPL, which corresponds to a WPL ratio of around 50%. The lower proportion of bond ETFs can be explained by the fact that WPLs are used for very liquid (heavily traded) bonds, e.g. B. government bonds of large industrialized countries, is economically unattractive, since there is insufficient lending demand for these securities. In such cases, the ETF provider will then contractually exclude WPL – similar to most swap ETFs – because this could lead to a small marketing advantage in this constellation.

We can therefore conclude that WPL is very likely to be carried out where it is economically attractive for the ETF.

(9) Should ETFs that lend securities be avoided?

In view of the foregoing, our answer to this question should not surprise any reader: WPL is anything but a negative characteristic, rather the opposite. Suppose the authors of this text were faced with the decision to choose between two ETFs that are identical in all of the characteristics we know and whose historical returns and tracking differences we do not know or which are ambiguous. The only difference between the two ETFs is that one practices WPL and the other doesn’t. Here we would choose the WPL-ETF because this ETF should produce a slightly higher return in the long run. This additional return adequately compensates for the minimal additional risk from WPL.

Conclusion

Over 90% of all physically replicating equity ETFs and around 50% of all bond ETFs operate WPL. It is an ETF attribute that is often wrongly criticized. Strangely enough, WPL is predominantly criticized only for ETFs, although WPL is also permitted under supervisory law for every other type of fund and takes place in practice. In our opinion, the criticism of WPL is mainly based on knowledge gaps and thinking errors and the wrongly bad image of short selling. At a higher level, WPL contributes to the information efficiency of the securities markets, which is of particular benefit to private investors and mostly passive ETF investors. At the direct ETF level, WPL improves the return that arrives in the wallet of private investors. This additional return represents adequate compensation for the minimal additional risk associated with WPL.

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