An even more lucrative approach than securities lending?


Demand for ETF shares is high from market makers and investors looking to hedge assets tracked by an ETF

A relatively new method of generating alpha in ETFs is starting to catch fire in Europe and could prove to be even more effective than securities lending.

Instead of issuers lending the underlying assets of an ETF, the ETF lending process involves an investor lending their ETF shares to the market, a move that can generate basis point returns. two digits.

The growth potential of this market is significant, according to IHS Markit, who argues that there are many reasons why physical ETF shares would want to be borrowed.

Figure 1: Lending opportunities vary depending on the instruments used

Source: IHS Markit

These include investors wishing to hedge assets tracked by an ETF, market makers actively involved in ETF pricing and the growing number of derivatives that track ETFs.

“Although ETFs have been around for more than two decades now, the asset class is still relatively under-represented in the securities lending market, which means that the growing group of investors looking to borrow ETFs often have to. hard to get hold of the most popular lines, ”IHS Markit said.

The lack of ETF loans for market makers is also a problem as it can be difficult to short sell many ETFs in Europe, especially compared to the United States.

As one industry source put it ETF flows: “In many cases, the lack of loan availability causes ETFs to trade at a premium until a market maker ends up creating the ETF to cover the shorts.”

IHS Markit said that income from ETF loans – which are made by investors themselves – can “significantly exceed” income from issuers’ securities lending programs, a process that is more commonly associated with the ETF envelope.

AJ Bell is one of those companies that has undertaken ETF loans. According to Matt Brennan, the company’s head of investment management, AJ Bell started lending ETFs about six months ago after three years of market analysis.

Speaking to ETF flows Big call: fixed income ETFs Event last month, Brennan said the ETF loan market in Europe has grown from around $ 30 billion to $ 70 billion since they’ve been monitoring the space.

Lending their fixed-income ETFs, in particular, has been a particularly lucrative process, Brennan said, especially in the low-yield environment investors find themselves in.

“The search for alpha is never without risk, but we believe that engaging in ETF loans… is a good way to improve returns,” he said.

“Our approach is to diversify the counterparties and limit the amount we lend to 15% of the overall portfolio. High yield bonds, euro companies and US Treasuries are areas where returns have been strong. “

One area of ​​interest for investors is the compatibility of securities lending in the ESG ETF space in the midst of concerns, this process facilitates the short selling of underlying assets and leaves issuers without a vote on resolutions.

On the transmitter side, DWS has started securities lending on a number of ESG ETFs this year as part of a process the company claims to be in compliance with its ESG standards.

On the ETF lending side, Brennan said investors can earn double by lending ESG ETFs compared to regular ETFs, which can create “an even greater moral dilemma.”

“It is important to understand to which counterparties you lend [with ESG ETFs] and titles are not used for “bad” purposes, “he stressed.

The ETF lending market will undoubtedly grow rapidly over the next few years, as more and more investors – drawn by the promise of even higher returns than securities lending – begin the process. borrowers stay.

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