Exchange-Traded Fund + Alpha Sharegain

Passive investing and the hidden alpha

The rise of ETFs

The exponential growth of passive investment over the past decade has been vastly applauded. ETFs – which track a certain index and trade like a normal share – have attracted such huge amounts of capital that in 2017 Moody’s estimated that passive funds currently account for 29 percent of the U.S. market and will overtake active funds market share by 2024. The numbers are so staggering that over the last 2 years alone, nearly $1 trillion was switched from traditional actively-managed mutual funds into passive ETFs and as a consequence global ETF AUM has risen sharply to $5 trillion.

As part of their low-cost tracking strategy, ETF managers have widely adopted the common practice of securities lending in an attempt to reduce their management fees and generate a new source of revenue for their respective funds. In fact, of the managers representing 95% of AUM in ETFs only two are not lending, which demonstrates how ubiquitous securities lending has become for ETFs.

The hidden alpha

The growth of ETFs, and their adoption as a valuable investment tool, has driven demand to borrow the ETFs themselves for strategies such as macro hedging, trade settlements etc. This demand has been reflected in the steady rise of on-loan balances within the Securities Lending marketplace, from $3 billion in 2015 to over $5 billion today (an increase of 75%) over the last few years.

Lendable ETF inventories
Source: ESMA

The increased demand for borrowing ETFs has come from a number of sources. For example:

  1. Increased adoption of ETFs as a macro-hedging tool by hedge funds and traditional asset managers who are using ETFs to tactically trade segments of the market.
  2. An increasing awareness of the need to settle ETFs on a timely basis – which is a particularly sensitive issue for overseas investors in Latin America and Asia – is driving increased appetite by market makers to borrow ETFs.
  3. The growth in secondary activity (such as the nascent options market in ETFs in Europe) which will fuel further demand in the long term (adopting similar patterns to the US options market, where High Yield Fixed Income ETFs in particular, have seen borrowing demand near 100%).

Such increased demand is not currently being met with corresponding levels of supply, which naturally translates to a rise in the lending rates of many ETFs as a whole, and European ETFs in particular. In fact, there are now over 150 ETFs globally where the annualised average lending revenue outweighs the cost of the ETF management fee. In reality, that means buying an ETF to track an index and invariably beating its results just by lending it out. Pure alpha!

Looking at the securities lending market as a whole, the latest bouts of market volatility and the imminent end of the QE paradigm has broken down correlations and seen the re-emergence of long/short strategies as an alpha generator. Assets flowing into hedge funds in early 2018 have hit levels not seen since before the financial crisis – with equity long/short strategies receiving 40% of the new money inflows.

Such strategies naturally require securities borrowing and the securities lending market in 2018 has witnessed its best first quarter in the last decade.

Q1 lending revenues
Source: IHS Markit

Beating the market regularly is hard, even for market professionals. Legendary investor Peter Lynch once said: “In this business, if you’re good, you’re right six times out of ten. You’re never going to be right nine times out of ten”.

Why not both improve your yield and mitigate portfolio volatility by adding a new stream of income from assets you already own?

Level the playing field

The securities lending market is opening up and going through major changes and we are proud to be at the heart of it and bring this industry to the digital age. Last month, our CEO, Boaz Yaari, participated in a thought-leadership panel about the future of our market and introduced Sharegain’s Digital Securities Lending Agent™ at the Securities Finance Tech Symposium held in London.

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Future Market Structure

This blog post contains information about Securities Lending. The information is not advice, and should not be treated as such. The views expressed in this newsletter are those of Sharegain Limited. If you decide to lend your securities your capital may be at risk. All investments involve investment risk, the value of investments and any income from them may go down as well as up. Past performance is not a guarantee or a reliable indicator of future results. If you are in any doubt as to the suitability of an investment to you, you should consult an appropriate professional advisor.