Few need reminding of the popularity of passive investing or of the success of passive exchange-traded funds (ETFs) with their sometimes mouthwateringly thin total expense ratios (TERs).
But not all ETFs are the same. In particular, synthetic ETFs, which seek to replicate the performance of an index using derivatives, are seen as relatively risky. This is because they are based on agreements with counterparties, such as investment banks, who could fail to meet their obligations.
By contrast, physical ETFs, which hold the underlying securities of an index, are comparatively safer and have proved more popular with investors. It is perhaps small wonder, then, that synthetic ETF providers have changed their approach.
‘Synthetic ETF providers such as DB X-trackers and Lyxor have been going physical in the past five years. This is because they were losing market share to physical ETF providers,’ said Kristopher Heck, chief investment officer at Tanager Wealth Management.
Indeed an October 2016 press release from Deutsche Asset Management, provider of DB X-trackers ETFs, said: ‘Further DB X-trackers … switches from synthetic to physical replication are due to take place. Once the switching process is complete, the majority of DB X-trackers ETFs tracking both equity and bond markets will be physical replication funds.’
Even so, physical ETFs can face risks that synthetic ETFs cannot, through securities lending. This happens when investment funds make short-term loans of equities or bonds to third parties and receive collateral in return, generally in the form of equities, bonds or cash. And the practice is widespread: research company IHS Markit estimated that, in September 2017, an average $2.3 trillion (£1.6 trillion) of assets was on loan each day.
Hedge funds typically use this kind of service. But Mark Fitzgerald, head of equity product management Europe at Vanguard, said: ‘Sometimes it’s not about hedge funds and short selling. The counterparties could be market makers or liquidity providers running many complex trades. They may have to deliver to one client but haven’t organised sufficient shares and so borrow temporarily for purposes of market functioning.’
But a recent Financial Times article, ‘Stock lending by ETF operators worries investors’, highlights the dangers of this practice. It points out collateral can be mismatched with, for example, equities held for loaned bonds. Or cash could be held for loaned equities or bonds. This cash has to be invested to achieve a return, which can lead to losses. Moreover, the counterparty could go bankrupt and fail to return the loaned stocks.
The article cites BlackRock’s iShares Core UK Gilts ETF, which loans around two-thirds of its assets at any one time, accepting equities and other ETFs as collateral. Heck said: ‘If you have mismatched collateral, such as equities for gilts, there may be a risk if gilts go up 2% and equities fall 5% at the end of the day. The disastrous scenario is that happens and the counterparty goes out of business that same day. Now you would be out of pocket, but hopefully this wouldn’t happen very often or indeed ever. Such an occurrence would be a Lehman Brothers moment.’
But this risk is not limited to ETFs. Fitzgerald pointed out other types of index trackers and even active funds can do stock lending.
Heck, though, said active funds can be less attractive to counterparties. ‘From the borrower’s perspective, it’s better to have a stable pot to borrow from. With a real active manager, you won’t know if they will sell off and call the loan back, which can be expensive. But an index fund manager will always, say, hold Microsoft.’
Protections in place
The history of stock lending by asset managers goes back decades. Indeed BlackRock started its lending programme in 1981.
Since then, only three borrowers with active loans from BlackRock have defaulted. BlackRock said it was in each case able to buy back every loaned stock with collateral on hand and with no losses to clients.
This period includes the 1987 stock market crash, the dotcom bust of the early 2000s and the financial crisis. As such, BlackRock’s track record offers some reassurance to investors concerned about stock lending.
Furthermore asset managers must, according to rules set by the European Securities and Markets Authority, disclose whether they engage in stock lending in their fund prospectuses. And Securities Financing Transactions Regulation requires reporting of all securities lending trades and ongoing disclosures by funds regarding stock lending they undertake. In short, the risk management policies and disclosures adopted by asset managers offer some protection to investors.
BlackRock, for example, discloses its funds can lend up to 100% of their assets. But, for the BlackRock Global Funds, less than 8% on average was lent for the year to 30 September 2017.
Fitzgerald, meanwhile, said Vanguard imposes a 7.5% maximum limit on stock lending for each of its ETFs, with a limit of 15% on its mutual funds. ‘But we rarely go above 2% on a fund at any given time,’ he said.
Moreover, BlackRock discloses borrowers must provide an excess. As such, collateral must be at least 102.5% of the loan value. And Lynn Hutchinson, head of passive product research at Charles Stanley, added: ‘Generally, collateral is received and is 102% to 112% of the stock lend, depending on the provider and the nature of the stock lent. It’s not without risks, but there are safeguards in place.’
Hutchinson also pointed out that, unlike an active fund, the ETF says how much is on loan and what the collateral is. ‘It’s on the website and is much more transparent than with active funds,’ she said. ‘This transparency is just down to how they do things: the technology is often better on ETF managers’ websites.’
She added that, in many cases, asset managers put indemnities in place to help protect investors in their funds. ‘So if there’s a shortfall in collateral then that would be reimbursed by, say, BlackRock or Deutsche Asset Management and not by the fund,’ said Hutchinson.
Risk and reward
What, then, should investors look for in asset managers’ stock-lending policies? Heck said: ‘You have to check if they have a sensible collateral policy. Most larger lending agents, such as State Street, BlackRock, Vanguard, Northern Trust, Bank of New York, and L&G have sensible policies here, from what I can understand. Post-Lehman, everyone is aware one of your counterparties can blow up.’
Regarding mismatched assets, it is important to check there is marking to market every day, according to Hutchinson. And the collateral should be topped up on a daily basis if its value against the loaned assets changes. She said: ‘As long as there’s security in the background and there are teams ensuring collateral is received etc. then it should be fine.’
Hutchinson highlighted BlackRock’s ‘rigorous’ process for assessing counterparties. ‘They have a risk team that assesses who they lend to and the borrower’s background,’ she said. ‘It’s not just lent to anybody: it’s to large institutions.’
Securities lending, though, offers a significant advantage to fund investors: it can help lower charges and lead to lower TERs. This can particularly benefit ETFs, with their relatively low expense ratios.
For example, in the year to 30 September 2017, BlackRock’s BGF European Focus fund gained 0.01% (1 basis point) from securities lending; BGF World Mining gained 0.02% from the practice; BGF Euro-Markets gained 0.03%; BGF Emerging Europe gained 0.05%; and BGF New Energy returned a very healthy 0.14% from stock lending.
Indeed Fitzgerald said: ‘Another way to think about securities lending is it can make assets work harder for the benefit of investors. Managers are in a situation where they are sitting on assets that could have value to help offset fund charges.’
So, while there are risks with securities lending, there are also benefits. Hutchinson pointed out that those unwilling to take on these risks can invest with HSBC, Invesco PowerShares or some smaller asset managers, as these do not engage in the practice.
Fitzgerald said those willing to take on the risks need to check out the policies on a manager-by-manager basis. ‘Investors should seek information on the lending programmes of the managers in which they are invested,’ he said. ‘Practices can differ wildly between fund houses and individual funds: you need to know what you’re buying.’
In the end, though, Heck thinks the risks of securities lending in physical ETFs are dwarfed by the risks of synthetic ETFs. ‘If securities lending from a physical ETF is like a firecracker burning your finger, then counterparty risk in a swap-based ETF is dynamite,’ he said.