Global ETF lendable assets have increased by $58 billion in 2018 compared with 2017’s average, according to research by IHS Markit.

Sam Pierson, Director of Securities Finance at IHS Markit.

The $52bn in average balances quarter-to-date (27 November 2018) is the highest on record for any quarter, despite the sell-off in global assets.

The good news for ETF holders is that utilization of lendable supply has also trended up this year, from 9.1% in Q1 to 11.3% in Q4, reports Sam Pierson, Director of Securities Finance at IHS Markit.

This has led to year-to-date revenues of $342m associated with lending those portfolios. This is poised to soon beat 2017’s total revenue of $345m.

Although equity ETFs bring in the bulk of total revenue from lending (accounting for 75% of revenue QTD, up from 70% in Q3), the ETFs leading the pack in terms of revenue generation are the USD high-yield index trackers – the iShares iBoxx High Yield Corporate Bond ETF (HYG US) and the SPDR Bloomberg Barclays High Yield Bond ETF (JNK US).

Source: IHS Markit.

Pierson notes that the growth in ETF lendable assets reflects the growing use of ETFs by institutional investors who are increasingly being drawn to the investment vehicle due to operational ease of use.

He writes, “The continued proliferation of exchange-traded products shows no sign of stopping, both in terms of AUM and product count. The Q4 sell-off has only reduced AUM to the level observed in Q2 and is still 5% above Q4 2017.”

Pierson continued “Holders of these products continue to see increasing total revenues and the increasing utilization means that returns to portfolios in lending programs are also increasing as a percentage of assets.”

Short sellers remain the key driver of borrowing demand. ETFs are popular with these traders as “they allow for the efficient expression of a view on a wide range of asset classes. That allows hedge funds to gain short exposure to a given sector or asset class, both as a directional view or as a hedge to a specific long,” notes Pierson

The $52bn in borrowed ETFs QTD equates to roughly a third of short positions reported to exchanges. The other two thirds are largely created from borrowed fund constituents which are exchanged for units of the ETFs.

Pierson adds, “The ability to ‘create to lend’ often keeps a lid on the lending fees for holders of the ETFs; however, the products which are more challenging to create can still command non-GC rates (for example, JNK and HYG currently have fees greater than 200 bps.)”

Not all ETFs can be created out of borrowed securities, however, such as those with exposure to illiquid asset classes. Pierson points to the Invesco Senior Loan ETF (BKLN US), which consists of a basket of leveraged loans, as a prime example.

Favourable characteristics

So what factors lead to an ETF being favoured for lending?

Generally speaking, notes Pierson, hedge funds would prefer to be short ETFs with higher expense ratios, as that is a direct drain on the fund’s performance; however, most funds will achieve securities lending revenues which partially offset the fund expenses, making this analysis less precise for funds which lend.

The liquidity of the ETF shares is another factor in selecting ETFs for short positions. Looking at the S&P 500 tracking funds as an example, the SPDR S&P 500 ETF Trust (SPY US) has a higher expense ratio than the Vanguard S&P 500 ETF (VOO US), and is also more liquid in the cash market, making it the preferred choice for short sellers.

Pierson writes, “That preference is clearly expressed in the comparison of short balances, where SPY currently has over $50bn, more than 100x the short balances in VOO.”