Most ETF investors never think about securities lending, but it quietly affects the returns of nearly every index fund you own. When an ETF lends shares from its portfolio to borrowers, it earns fee income that flows back into the fund. This extra revenue can partially or fully offset the expense ratio, making the ETF cheaper to own than its stated fee suggests.
How Securities Lending Works in ETFs
The basic mechanics are straightforward. An ETF holds hundreds or thousands of stocks and bonds. Some of those securities are in high demand from borrowers -- typically hedge funds and institutional investors who want to short sell or use the securities for other trading strategies.
The ETF's custodian or a designated lending agent identifies borrowable securities in the portfolio and lends them out. The borrower pays a fee for the privilege and posts collateral worth 102-105% of the loan value. The lending agent invests the cash collateral in short-term, low-risk instruments and returns the securities when the borrower is done.
The income from lending fees and collateral reinvestment flows back to the ETF's net asset value, benefiting all shareholders.
Why Securities Lending Matters for Your Returns
Every basis point counts in index investing. When two ETFs track the same index, the one with a more effective lending program may deliver better returns despite having the same stated expense ratio.
Offsetting the Expense Ratio
For a large-cap ETF with a 0.03% expense ratio, even modest securities lending income of 0.01-0.02% can offset a third to half of the fund's costs. For small-cap ETFs or niche products where borrowing demand is higher, lending income can exceed the expense ratio entirely, resulting in negative effective costs.
Beating the Index
This is why some ETFs actually outperform their benchmark index despite charging a fee. The index itself does not benefit from securities lending, but the ETF does. If an ETF charges 0.03% but earns 0.05% from lending, it may deliver a tracking difference of +0.02% relative to the index -- better than zero-cost theoretical tracking.
How Much Income Does Securities Lending Generate?
The revenue varies enormously depending on what the ETF holds and how much demand exists for borrowing those securities.
Large-cap US equity ETFs (like those tracking the S&P 500) earn relatively little -- perhaps 0.01-0.03% annually. Large-cap stocks are widely held and easy to borrow, so lending fees are low.
Small-cap and mid-cap ETFs earn more -- typically 0.05-0.20%. Smaller stocks are harder to borrow and more frequently shorted, commanding higher lending fees.
International and emerging market ETFs can earn 0.10-0.50% or more, especially for markets where short selling is more difficult or where regulatory requirements increase borrowing demand.
Specialty and thematic ETFs holding heavily shorted stocks can earn the most. During periods of high short interest, individual stock lending rates can spike to 10-50% annualized, though these extreme rates apply to only a portion of the portfolio.
Securities Lending Revenue: Who Keeps What?
Not all of the lending income goes to the fund. The split between the ETF and the lending agent varies by issuer, and this is a meaningful differentiator.
Vanguard returns 100% of securities lending revenue to its funds. The lending program is managed internally, and all income benefits shareholders.
iShares (BlackRock) splits revenue with its lending agent, BlackRock's securities lending arm. The standard split has historically been around 60-65% to the fund, with the rest going to BlackRock. However, the actual percentages can vary by fund.
State Street (SPDR) also splits revenue between the fund and its lending operation. The exact terms vary by fund and are disclosed in the fund's annual report.
This revenue split is one of those details that rarely makes headlines but can affect long-term returns, particularly for index ETFs where every basis point of cost matters.
The Risks of Securities Lending
Securities lending is generally low-risk, but it is not risk-free. Here are the main concerns.
Counterparty Risk
If the borrower defaults and cannot return the securities, the ETF is exposed to loss. However, the overcollateralization requirement (102-105%) provides a cushion. The ETF can sell the collateral to buy back the lent securities. In the 2008 financial crisis, some securities lending programs experienced losses when cash collateral was invested in instruments that lost value, but regulatory changes since then have tightened collateral reinvestment rules.
Collateral Reinvestment Risk
Cash collateral is typically invested in money market funds or short-term debt instruments. If those investments lose value, the ETF may not be able to return the full collateral to the borrower while also making the fund whole. Post-2008 regulations have reduced this risk by limiting collateral reinvestment to high-quality, short-duration instruments.
Reduced Voting Rights
When securities are on loan, the borrower -- not the ETF -- holds the voting rights. This means the ETF cannot vote on shareholder proposals for lent shares. Some issuers recall shares before important votes, but this practice varies.
How to Evaluate an ETF's Lending Program
If you want to dig into the details, here is what to look for.
Annual report: ETFs disclose securities lending income in their annual and semi-annual reports. Look for the line item showing lending revenue and the percentage of the portfolio on loan.
Revenue split: Check how much of the lending revenue goes to the fund versus the lending agent. This is typically disclosed in the fund's Statement of Additional Information (SAI).
Collateral policy: Review what types of collateral the fund accepts and how cash collateral is reinvested. Conservative reinvestment in government money market funds is preferable.
You can compare ETFs on ETF Beacon to evaluate funds side by side, including their total cost of ownership after accounting for lending income.
Securities Lending and ETF Selection
Securities Lending in Different ETF Categories
The importance of securities lending varies significantly across ETF types.
For large-cap US equity ETFs tracking the S&P 500, lending income is a small but meaningful contributor to returns. Funds like SPY, VOO, and IVV all participate in lending programs, but the income generated is modest because large-cap stocks are widely available to borrow.
For small-cap and mid-cap ETFs, securities lending is a bigger deal. Smaller stocks are more frequently shorted and harder to borrow, which means lending fees are higher. An ETF like IWM (Russell 2000) can earn meaningfully more from lending than a large-cap fund, and this income can significantly improve the fund's tracking difference relative to its benchmark.
For bond ETFs, securities lending dynamics are different. Bond borrowing demand exists but is generally lower than for equities. Treasury ETFs may lend securities to support the repo market and short-selling of government bonds. Corporate bond ETFs have more limited lending opportunities because individual bond issues are less standardized and harder to borrow.
For international and emerging market ETFs, lending can be quite lucrative. Securities in markets with restrictions on short selling or limited supply can command premium lending fees. This is one reason some international ETFs deliver better tracking than you might expect given their expense ratios.
Securities Lending and ETF Selection
For most investors, securities lending should not be the primary factor in choosing an ETF. But when you are deciding between two otherwise identical funds -- say, two S&P 500 ETFs with similar expense ratios -- the one with a more generous lending program may deliver slightly better returns over time. It is one of those small advantages that compounds quietly in the background, and it is worth understanding even if it never changes your investment decision.
