Equity exchange-traded funds (ETFs) have been engaging in securities lending for decades. But recently, ETFs began reporting the securities lending activities separately from the funds’ core business income after regulators all over the world enacted regulations designed to better inform retail investors about a fund’s actual performance and risks. The authors assess the implications of securities lending operations for US equity ETFs’ financial performance to help inform the decision making of retail investors.

Securities lending has been a profitable business for ETFs over the past decade. The authors examine the impact of securities lending activities on the return performance of US equity ETFs. They confirm that income from securities lending has moved up significantly in recent years and was at very high levels during the financial crisis in 2008. ETFs use this income from securities lending activities to enhance returns because doing so reduces tracking errors considerably over time. The actual performance is determined from the actual performance of the stocks underlying the ETF in the form of dividends and capital gains or losses and returns from securities lending.

The authors note that small-cap ETFs tend to gain significant returns from lending securities in relation to large-cap ETFs because the short supply of small-cap stocks enables them to generate higher lending rates, thereby outperforming the benchmark. These lending activities are susceptible to borrower default risk and collateral reinvestment risk. The findings of this research have implications for investors, especially those who use tracking error to judge the performance of ETFs. ETFs that engage in prudent securities lending can reduce the burden of investment management fees and enhance returns.

The authors obtain samples of large-cap, mid-cap, and small-cap US equity ETFs from the ETF database. They include value and growth ETFs but exclude leveraged ETFs. They obtain from various sources the year-end net asset value, securities lending data, expense ratios, and tracking error data for 2004–2012 for each category of fund. A simple tabulation of the entire dataset for each category shows a rise in the expense ratio and a fall in the tracking error attributable to securities lending operations over the period.

Incremental returns (i.e., additional returns from securities lending) for each ETF are computed for each year the ETF engaged in securities lending. The performance enhancement is calculated as the incremental return from the securities lending divided by the ETF’s adjusted tracking error, which is the incremental return added to the reported tracking error. The results indicate that the reported tracking error for the average ETF for all three categories improves because of securities lending activity. The improvement was greater during the financial crisis, when the lending activity was at its peak.

Securities lending introduces risk to ETFs, much of which has been mitigated by issuer policies. In addition, the benefits of securities lending range from negligible to highly significant. In the case of index-based ETFs, such activities may result in returns that can partly offset an ETF’s management fee, thereby helping match the performance of its reference index. The scope and scale of ETF securities lending activity differs across jurisdictions and even among ETFs within the same jurisdiction. Disclosure of fees, expenses, and types of risks to investors, particularly the use of complex strategies that may use leverage, brings transparency.