How would you like a money manager who pays you for the privilege of running your portfolio?
You get that deal at 16 of the 737 funds on the Forbes Best ETFs list. They’re so efficient that the cost of holding them is a negative number. This marvelous result is made possible by the science of securities lending. Short-sellers have to borrow shares for their dirty work. They pay a fee for the loan, in addition to promising an eventual return of the shares and reimbursement for any lost dividends. Funds collect these fees on behalf of fund shareholders. Those fees offset, and in some cases more than offset, the expenses of running the fund.
Consider the SPDR S&P Telecom ETF (XTL) from State Street Corp. (STT). In the six months to Dec. 31, XTL hauled in $367,000 in lending revenue, far surpassing the $102,000 State Street charged as a management fee. For this fund I calculate (using lending data for a full year) a long-term holding cost of -$648 per $10,000 invested.
Funds that own large-company stocks like Exxon Mobil have modest revenue from securities lending; Exxon shares available for borrowing are plentiful and fees meager. But funds with speculative or foreign stocks can do very nicely with the share lending sideline.
XTL owns some blue chips like Verizon and AT&T, but it has larger positions in such companies as NetScout Systems, which sells communications security, and Infinera, a fiber-optic firm. It may or may not be a good idea to load up on a high-tech portfolio like this one late in the bull market, but if you do want to own stocks like NetScout, XTL is the best way to own them.
Buy NetScout directly and you probably won’t see any revenue from lending your stock to the short-sellers who, at last count, had shorted 11 million of the company’s 80 million shares. It’s likely that your brokerage firm will help itself to any NetScout you leave in a margin account and never inform you about the resulting income. (Your brokerage statement will show the same NetScout holding, whether or not the shares are off the premises.)
Fund operators are in a different fiduciary position. While they can skim some of the lending revenue, they have to tell fund investors what they’re doing. Among the other funds with lending operations that result in negative holding costs: Vanguard FTSE All World ex-U.S. Small Cap (VSS), with a cost to you of -$223 per $10,000 over ten years, and iShares Core S&P Small-Cap (IJR), at -$51.
A typical lending arrangement works like this. A short-seller betting against NetScout puts up $102 of cash collateral in order to borrow $100 of NetScout shares. The lender of the shares invests the cash. Supply and demand determine the terms of the deal. If lendable shares are plentiful, the short-seller and the lender will split the interest income earned on the cash. When lendable shares are scarce and short-sellers abundant, the terms swing in favor of the lender: The lender will pocket all the interest plus a lending premium from the borrower.
Your fund won’t tell you the terms of any of its share loans, but you can get an idea of what’s going on by looking at its income statement and balance sheet. The sec lending revenue at XTL (a line on the income statement in which interest and premiums are lumped together) is very large in relation to the $4.5 million value of shares out on loan. Evidently some of the shares in its portfolio are very avidly sought by bears.
Whatever the terms on interest splits and premiums, the short-seller is obliged to make the lender whole. That means compensating the lender for missed dividends and replacing the shares on demand. If NetScout goes up in price, the borrower has to put up more cash collateral within 24 hours.
Could anything go wrong? It could, although I can’t cite a recent case of a fund losing money on its stock loans. Suppose Symantec takes a liking to NetScout, offering a 50% premium in a merger. The short-seller has to come up with $150 to buy in the shares that were worth $100 the day before. If the short goes bankrupt and if there’s no stock lending agent in the middle to backstop the transaction, the fund could lose $48.
The other hazard has to do with the cash. If the fund invests it badly, it will be the loser—it owes $102 to the bear no matter what. The usual practice, though, is to put the money in a fairly safe place. Invesco’s collateral, for example, goes into its Short-Term Investments Trust Government & Agency Portfolio, a collection of AAA-rated paper with a recent yield of 1.8%.
Among ETF operators, BlackRock (BLK) is the runaway leader in securities lending. If it can continue to deliver the same percentage returns that it did in past fiscal years to its current asset base, it will hand customers of Forbes Best ETF funds $455 million this year by lending out their assets. Vanguard is a distant second-placer with an indicated $214 million payday.
State Street, Schwab, Invesco, Wisdom Tree and DWS (the wealth management arm of Deutsche Bank) all have lending revenue that is significant in relation to their ETF assets in our survey.
Vanguard notes pointedly that it plays the sec lending game very conservatively, paying close attention to counterparty risks. BlackRock is more aggressive, lending out bonds as well as stocks; that’s how its iShares Interest Rate Hedged High Yield Bond (HYGH) gets to the top of our cost-efficiency list for junk funds. But it protects shareholders by promising to indemnify them for losses caused by defaulting borrowers. Also, the borrowers are not entities like Joe’s Hedge Fund LLC; they are firms like JP Morgan and Goldman Sachs.
Vanguard also takes pride in remitting to shareholders all lending revenue after subtracting only the direct costs of running its stock loan department. BlackRock, in contrast, peels 28.5% off the top. But how the loot is split is immaterial to the calculations in our cost ratings. All that matters is the net cost of the fund: the expense ratio minus whatever the fund customers get from lending.
There’s a small tax downside to stock loans. The income from investing the collateral, from the lending premium and from the reimbursement for lost dividends is all taxed at high ordinary-income rates, not the reduced rates for most dividends. But that’s a small price to pay to get bargain money management.