Since the launch of the first European exchange-traded fund (ETF) in 2000, the rapid adoption of UCITS ETFs has been an incredible phenomenon. For the uninitiated UCITS stands for Undertakings for Collective Investment in Transferable Securities, a popular regulatory framework that allows for the sale of cross-Europe mutual funds and ETFs.

With a wide range of options available, picking a UCITS ETF that will meet investment goals requires in-depth analysis. Generally, due diligence focuses on the expense ratio, portfolio composition, performance, AUM, and average daily trading volume. Although these are key considerations, a UCITS ETF’s securities lending program can be a key differentiator. Despite potential benefits for investors, namely an additional revenue stream, securities lending is often overlooked as an important element of the due diligence process.

Article Summary

• What is securities lending
• How does securities lending work
• What are the benefits to UCITS ETF investors
• Review of securities lending regulation
• What are the potential risks of securities lending

What is Securities Lending?

In order for an investor to borrow a stock, they need to acquire it from a current shareholder. UCITS ETFs make good supply-side candidates for securities lending given that they tend to have a portfolio of large positions that are liquid. The individual stocks within an ETF are usually borrowed through an intermediary called a securities lending agent (often an affiliate of the UCITS ETF’s depositary). The lending agent negotiates terms and arranges the loan with counterparties on behalf of the UCITS ETF.

With securities lending, the lending yield (how much it costs to borrow securities) is driven by demand. The more market demand there is to borrow a stock, the more a borrower is willing to pay. Similarly, the less demand, the lower the lending yield.

A common misconception is that borrowers are usually investors who wish to short a stock because they believe its value will fall. This is not necessarily the case. Other reasons that securities are borrowed include to facilitate the clearance of trade fails, to execute certain arbitrage strategies, and to provide a source of liquidity to market makers/primary dealers while supporting the investment strategies of asset managers.

When a UCITS ETF lends a stock, collateral is received in exchange. The amount of collateral changes based on the price of the borrowed securities. If the value of the underlying borrowed security goes up, the borrower will have to deliver additional collateral and vice versa. Regardless of a security being on loan, the UCITS ETF's total asset value includes that of the underlying security. In addition, all of the UCITS ETF’s corporate action elections and income are protected for shares on loan.

Benefits of Securities Lending for Investors

The primary benefit to UCITS ETFs that utilise securities lending is an additional income stream. The income earned from securities lending is usually estimated and accrued daily into the ETF’s NAV and is distributed on a monthly basis. Securities lending tends to increase when a UCITS ETF’s underlying asset class, sector, or market is out of favor or lacks liquidity (for some of the reasons stated above, i.e. for short-sellers or for market makers seeking efficient market making).

From a strictly GAAP (Generally Accepted Accounting Principles) standpoint, securities lending income is classified as its own line item of investment income and is not used to directly offset management fees on the income statement. When the securities-lending income stream is juxtaposed against the management fee, the overall cost of ownership of a UCITS ETF can be thought of as being significantly reduced given the general offsetting economic impact of income versus fees. Viewed this way, securities lending income may improve the cost of UCITS ETF ownership, compared to the same strategy without a securities lending component. While securities lending revenue can vary day to day, an investor can find the management fee and historic data on securities lending income in a UCITS ETF's Semi-Annual and Annual Report.

For illustrative purposes, one can reference the KraneShares US 2019 Annual Report in which the U.S. -listed KWEB ETF's securities lending income was stated as $11,054,366 and securities lending fees totaled $3,095,222.  Total assets under management during the same period were $1,733,463,339, resulting in a contribution of net 46 basis points (bps) from securities lending income and offset of over 60% of management fees.

Regulation

Securities lending for UCITS ETFs authorised in Ireland is regulated by the CBI (Central Bank of Ireland) which has implemented the relevant ESMA (European Securities and Markets Authority) guidelines. The lending cap and eligibility of collateral applicable to the UCITS ETF’s securities lending program must comply with CBI requirements but can generally be determined by the ICAV board of directors within the framework of those regulations. The regulations do not set a maximum percentage of UCITS ETF’s portfolio that can be lent out. Still, each UCITS ETF must disclose both the maximum and expected percentages of securities lending usage in its offering documentation.

Today, it is common practice to permit receipt of non-cash collateral only, which is typically limited to G-10 sovereign debt; however, a borrower may elect to substitute non-cash collateral with other eligible securities of equal to or greater value. Approved non-cash collateral may be received, held, and administered by the UCITS ETF’s depositary or a third-party collateral manager (“Tri-Party Institution”) pursuant to authorisation granted by the ETF under a Securities Lending Agency Agreement and are marked to market daily by the Tri-Party Institution in accordance with the methods prescribed under the Collateral Management Agreement.

In addition, securities lending programs may set certain compliance requirements as safeguards to protect the UCITS ETF, such as security level buffers which cap the amount of a particular security that can be loaned out and margin requirements that are greater than the value of the securities being loaned. As previously noted, the amount of collateral is adjusted daily based on the securities rising or falling in value. These safeguards are in place to protect the ETF’s shareholders.

Risk Overview

As with all investments, understanding risk factors is a key part of the equation. We believe the best tool to mitigate risk is performing due diligence and analysis before investment decisions are made. KraneShares partners with Brown Brothers Harriman (our lending agent and custodian) to address four key risk components related to securities lending: program risk, collateral reinvestment, counterparty risk, and operational risk.

Given the benefits of securities lending, we encourage investors to incorporate this data point into their due diligence process and further examine the securities lending practices of the UCITS ETFs that they are considering. The income stream from securities lending may produce a meaningful reduction in the cost of owning a UCITS ETF.