While providers of exchange-traded funds battle for customers by offering the lowest fees on their products, there’s another way of reducing the cost of owning them where demand is booming.
It’s the lending market, where institutions have long buttressed their bottom line by making shares available to borrowers who use them for purposes such as going short.
While a vast mechanism exists for getting individual stocks into the hands of those who would take them on loan, new research says lending out ETFs is where institutions and individuals could be making a lot more money.
The way it works is fairly simple. An investor is holding an ETF as a long-term position but is willing to lend the fund’s units to short-sellers, most often hedge funds, that want to bet against it in the short-term, according to Eric Balchunas, an ETF analyst with Bloomberg Intelligence.
On average, the fee paid by the borrower enables the ETF holder to recoup 40 percent of the fund’s cost, and in some cases receive full compensation -- or more, according to an IHSMarkit report published last week.
In this way, the strategy can turn into a money maker for the lender without disrupting it’s long-term investment. There’s scope for the practice to become more readily available to individual investors, Balchunas said.
‘Is there space for a service to let retail investors gain access to ETF lending? I could see this happening because it’s in line with the democratization of investing that ETFs are helping bring on,” he said. “You essentially have hedge funds subsidizing ETF investing.’’
Unexplored Revenue
The practice is unique to ETFs, which, because of their stock-like structure, can be borrowed to short, unlike most other types of funds, Balchunas said. The strategy is more applicable to institutions than individuals because they have the infrastructure to complete the transactions. And it’s distinct from the other form of ETF shorting, where the funds lend the underlying shares in their portfolios and have the option to put the fees they collect back in to improve returns.
The strategy of directly lending ETF units represents a tiny corner of the market. Just 5 percent of ETF assets are in funds with lending programs, which is “woefully behind conventional equities considering that over a quarter of the Russell 3000’s market cap now sits in lending programs,” according to IHSMarkit.