ETFs and Securities Lending: A Tantalizing Pairing

In light of Blackrock’s European ETF event in London yesterday we are going to look at the pairing of ETFs and Securities Lending. We can come at this from all angles but securities lending seems a good starting point. To me the big picture is this: do investors want to invest or trade? The answer here will dictate the value of ETFs versus ordinary shares and have a knock on impact in the securities lending world.

It is no secret to anyone that lending and borrowing is one of the 6 pillars in the “why use ETFs” mantra, according to Blackrock’s (makers of iShares) handbook from Q2 2010. From looking at the Data Explorers peer group, we see that US institutional investors hold many more ETFs than their European equivalents by about 6:1. Further, these super funds who lend (as a proxy for professional investors in general) own almost $7 trillion of plain global equities versus $65 billion in ETFs, which is a mere 0.97% of their total equity holdings. This is slightly misleading in that brokers can create as much of an ETF as they want (generally), but it tells you the extent to which funds are switching from stock picking to ETF trading. In October 2007, the figure stood at 0.7% so there has been some change but it is not a stampede!

The growth lies in the European ETF inventory - an increase of 209% year on year, while the US has seen a 30% increase from a higher base. Asia remains barren in contrast! The US dominates with, unsurprisingly, the S&P500 tracking ETF the most popular to own (State Street’s SPY). Then, there is a rash of emerging markets funds and gold is in the top 10 (see chart and for more on this please email media@dataexplorers.com).

The big debate is quite simple: will ETFs overtake single equities as the common way to invest, and if so where and how soon? The answer to this will have a major impact on the profitability, and scale ofsecurities lending. I say, “scale of” since the decreasing need to borrow single names to support directional shorting in the US is stark, whereas the income from lending ETFs is 4.5 times more profitable than lending US equities at present.

A further element in the debate about ETFs is also about who should keep the securities lending revenue between the fund holders and the asset management firm or shareholders. Securities lending revenue from lending ETFs is key because demand is strong and margin tends to be very thin. However,Beneficial Owner’s can offset their Custody costs (although some don’t) by owning plain equities - so what is their motivation to switch to them? Sovereign Wealth funds are sticking with active equity managers for now – but for how long? See www.nbim.no for more on their Active Management approach. Of course, the most cunning use of ETFs could be as collateral as a liquid and neat counterpoise to a loan of similar instruments. How many banks take ETFs as collateral right now?

My own view is that ETFs versus ordinary shares boils down to whether people are interested in trading or investing. This is also the view of Vanguard’s founder ,John C. Bogle, who is aghast that you can trade an ETF of emerging Cancer-cure companies, for example. More trading and turnover means more costs (even if the costs are low) that drag on performance and take money away from investors and into the hands of those that process transactions - be they exchanges, banks etc. But is more trading the way to make more money?

Like it or lump it, European investors do not yet understand ETFs and most retail investors have not even heard of them. In the US, how many of the so called retail investors using ETFs are actually professionals investing in their spare time? I suspect this just tells you that it is the people who understand these instruments who trade them. There are plenty of Investment Trusts in London that mirror a wide variety of share performance – and many of these are often at wide discounts to the value of their holdings! How will these be affected by ETFs?

Why are people borrowing these ETFs? Consider Vestas Wind’s (VWS) profit warning. If you are a fund manager and have loaded up on European wind farm companies, a great way to hedge against a sector shock is to short an ETF that replicates the performance of Euro wind companies/ Though at present,the US investors do this far more than over here. A European hedge fund is more likely to hedge their long bias by asking their prime broker to create a custom basket of equities to short, known as a sector swap – or use futures or options. It is chicken versus egg syndrome – are they only doing this because there are insufficient European ETFs or because they prefer bespoke swaps in any case?

From a hedging perspective, the good news for securities lending is that you achieve a truer hedge by shorting an ETF than by buying the so called “inverse” ETFs that offer inverse performance to their constituents. An example is the Powershares Pro Short but these instruments are not mature or appropriate (is the nice way of saying it) – we are told.