The Impact of Securities Lending on ETF Returns and Risk

 

Introduction

The impact of securities lending on ETF returns and risk is often overlooked by many investors. Yet, understanding this subtle but powerful mechanism can help you make smarter ETF choices and optimize portfolio performance.

When you invest in an ETF, you’re essentially buying shares that represent a basket of underlying securities. But here’s what many don’t realize — ETF providers can lend out some of those securities to other investors or institutions in exchange for a fee. This process, known as securities lending, can generate additional income that may enhance your ETF’s total return.

However, like any financial tool, securities lending also introduces potential risks. These include counterparty risk (the borrower might default), collateral issues, and market exposure during lending periods.

In this article, we’ll explore how securities lending works, its influence on ETF returns and risk, and what you should look for when evaluating ETFs that engage in lending. Whether you’re a beginner building a balanced portfolio or an experienced investor seeking higher efficiency, this guide will help you understand the key dynamics of this often-hidden revenue stream.

How Securities Lending Works in ETFs

At its core, securities lending is a simple concept: an ETF provider lends securities it holds—like stocks or bonds—to other market participants, typically short sellers or institutions that need temporary access. In return, the borrower posts collateral, usually cash or high-quality securities, and pays a lending fee.

This fee becomes income for the ETF, which can help reduce the fund’s expenses and improve net returns. The ETF issuer (like Vanguard, iShares, or State Street) usually retains a portion of this income and distributes the rest to investors.

Moreover, securities lending helps maintain liquidity in the market. For instance, when a stock within an ETF becomes hard to borrow, lending programs ensure availability without significantly affecting market stability.

However, not all ETF issuers follow the same lending policies. Some are more conservative, while others actively lend to enhance yield. Therefore, always review the ETF’s prospectus or annual report to understand its lending program’s scope and safeguards.

Read more about ETF basics here →

The Positive Impact on ETF Returns

One of the most notable benefits of securities lending on ETF returns is the potential for incremental income. This extra revenue can make a measurable difference, especially in low-yield environments.

For example, ETFs tracking broad equity indexes often have modest management fees. Through securities lending, fund managers can offset part of those costs. In some cases, the net return improvement might be between 0.02% and 0.10% annually — a small but meaningful gain over time.

Additionally, funds that focus on less liquid or small-cap stocks tend to benefit more because such securities command higher lending fees.

However, investors should consider transparency. Some issuers disclose their lending revenue breakdown, while others provide limited visibility. A transparent report helps investors evaluate whether the added return justifies the associated risks.

According to Investopedia, securities lending income can be a key driver of ETF efficiency when managed responsibly.

The Potential Risks of Securities Lending

While the benefits are real, securities lending in ETFs introduces a few important risks. The most significant is counterparty risk — the risk that the borrower fails to return the borrowed securities.

To mitigate this, ETF issuers typically require collateral that exceeds the value of the lent securities (usually 102%–105%). However, if market prices move sharply, collateral can lose value, exposing the ETF to losses.

Another risk is cash collateral reinvestment. If the ETF manager reinvests the cash collateral into risky assets, unexpected losses could occur. While most managers use conservative instruments, investors should still verify the fund’s reinvestment policy.

Lastly, securities lending might affect voting rights. When shares are on loan, the ETF temporarily loses its right to vote at company meetings. This may influence corporate governance outcomes in subtle ways.

Understanding these risks allows investors to weigh whether the incremental income outweighs the potential downsides.

How to Evaluate ETFs Engaged in Securities Lending

When evaluating ETFs that participate in securities lending, focus on transparency, collateral policy, and income sharing.

1. Transparency: Look for ETFs that publish regular updates on their lending activities, including the percentage of assets lent and total income earned.
2. Collateral Quality: Ensure the ETF only accepts high-quality collateral like cash, government bonds, or blue-chip securities.
3. Income Distribution: Understand how the income is split between the issuer and the fund’s investors. Ideally, the majority of the income should benefit shareholders.
4. Historical Performance: Compare two similar ETFs—one that lends and one that doesn’t—to see the performance difference over time.

In addition, some ETF families, such as Vanguard or iShares, have robust risk management teams overseeing their lending programs, which can increase investor confidence.

Evaluating these factors will help you choose funds that maximize returns without adding excessive risk.

Balancing Returns and Risk: The Investor’s Perspective

From an investor’s viewpoint, the impact of securities lending on ETF risk depends on personal risk tolerance and investment objectives.

For conservative investors, even minor exposure to counterparty risk might feel uncomfortable. In that case, selecting ETFs with minimal lending activity—or those that fully insure lending operations—makes sense.

However, for growth-oriented investors, the incremental returns from lending may align with their goal of optimizing long-term performance.

It’s also essential to consider that securities lending may behave differently across market conditions. During calm markets, lending income remains stable. But in volatile periods, collateral management becomes critical.

Therefore, diversification remains your best defense. Combine ETFs with and without lending exposure to balance both risk and return potential in your overall portfolio.

The Future of Securities Lending in ETFs

Looking ahead, the role of securities lending in ETFs is likely to expand as the ETF industry continues to grow. The global ETF market surpassed $12 trillion in assets in 2025, and lending programs are becoming more sophisticated.

Regulators are also tightening transparency standards, requiring issuers to disclose more about their lending practices. As a result, investors can expect greater visibility and better governance.

Technological advancements—like blockchain-based collateral tracking—could further enhance security and efficiency in the lending process.

Ultimately, understanding how securities lending affects ETF returns and risk gives you an edge. By combining awareness with smart selection, you can invest confidently in ETFs that match your values, goals, and comfort with risk.

Conclusion

Securities lending is a powerful but often underappreciated aspect of ETF investing. It allows fund managers to generate extra income, which can enhance ETF returns, particularly in low-yield markets. However, this advantage comes with potential risks related to collateral, counterparty exposure, and governance.

By understanding how securities lending works and evaluating ETFs based on transparency and policy strength, investors can make informed choices that align with their risk tolerance.

In the long run, success with ETFs isn’t just about chasing performance — it’s about balancing opportunity with prudence. Whether you prefer a conservative or growth-oriented strategy, knowing the impact of securities lending on ETF returns and risk can help you build a more efficient, resilient, and profitable portfolio.

🗝️ Key Takeaways

1. Securities lending adds incremental income to ETFs, boosting returns modestly.
2. Risks exist, including counterparty and collateral exposure, but can be managed with transparent policies.
3. Smart ETF selection involves balancing lending benefits against your personal risk profile.

Further Reading on Mastering ETFs

Understanding Tracking Error and Premiums in ETFs
Passive vs. Active ETFs: Which One Wins Long-Term?
How Dividends Work in ETFs: Total Return Secrets
Index Funds vs. Individual Stocks: The S&P 500 Way
The Basics of Diversification: Why You Need More Than One Stock
Dividends: Income from the S&P 500

Disclaimer

This article is for educational purposes only and does not constitute financial advice. Please consult a licensed financial advisor before making investment decisions.