Analysts at Vanguard have taken a closer look at the differences in securities lending returns across funds.

Experts at the research house recently delved into an eight-year sample of data (2007-2014) from Morningstar on 1,193 US index funds and ETFs.

They then tested variables in an attempt to explain differences in the contribution of securities lending to fund returns, what Vanguard calls “lending impact".

“We found that cross-sectional differences in lending impact could be largely explained by the average proportion of a fund’s assets out on loan, the number of a fund’s portfolio securities, its fiscal year, its asset-class category, and its asset manager,” said James Rowley, a senior investment analyst in Vanguard’s Investment Strategy Group.

“Also, of note, we found no relationship between expense ratio and lending impact.”

Assets out on loan

Since a fund can only earn lending income to the extent it lends securities, it might seem obvious that a fund’s lending impact is determined in large part by how much the fund lends.

However, Vanguard’s research shows variation from the trend line can be a result of factors such as asset class and lending strategy.

One chart showed that the average proportion of a fund’s portfolio on loan explained more than 40% of the variation in lending impact.

Fiscal year

Fiscal year was another important variable because, just as returns for the broad stock and bond markets display cyclicality, it is possible that returns for the broad securities lending market display cyclicality.

Notably, lending impact was higher during the global financial crisis years of 2008 and 2009, an increase that can likely be attributed to two factors combined. 

"First, the high level of market volatility during the period could have created additional demand from short sellers, increasing the proportion on loan in 2008 and 2009 relative to other years," explains Rowley.

Second, and perhaps more important, scarcity premiums may have risen (i.e., rebate rates dropped). For example, S&P Indices (2010) noted that the S&P 500 financials sector sub-index was consistently priced at a negative rebate rate for second-quarter 2009.

Asset class

Vanguard also contended that a fund’s asset class would provide explanatory power.

Research suggests that US smaller-cap funds tended to earn significantly more than their large-cap counterparts.

International stock funds also tend to earn a lending premium relative to US large-cap funds, likely due to the benefits associated with the tax treatment of cash flows remitted to the lender that represent the dividend payment on the borrowed stock.

“Of note, we also found differences according to asset manager, which we believe to be a proxy for firm-level policies and procedures,” added Rowley.

Lending benefits

The index funds from Vanguard’s full sample had a weighted-average expense ratio of 23.6 basis points (bps) in 2014, the weighted-average lending impact of 2.7 bps helped offset more than 10% of the expense ratio in the same year.

“This is a significant benefit, because expense ratio is a critical determinant of an index fund’s return relative to its benchmark index,” the report concluded.