Securities Lending in Investment Portfolios: What Investors Need to Know

If you hold a low-cost index tracker ETF, your fund manager is almost certainly lending some of the underlying securities to third parties and generating additional income from doing so. Most investors are unaware of this. Even fewer understand who bears the risk. Securities lending is a legitimate, well-regulated practice that can improve fund returns — but it involves exposures that investors deserve to understand clearly.

This guide explains how securities lending works, how the revenue is shared, what the risks are, and how the UCITS regulatory framework governs the practice in the UK and EU. It is educational context, not financial advice; investors in specific funds should consult the fund's prospectus and Key Investor Information Document (KIID or KID) for fund-specific terms.

What is securities lending?

Securities lending is the temporary transfer of securities (shares, bonds, or other financial instruments) from a lender to a borrower, in exchange for:

1. Collateral from the borrower (cash, government bonds, or other eligible securities)
2. A lending fee (also called a securities lending fee or repo rate) paid by the borrower

At the end of the loan term, the borrower returns equivalent securities (not necessarily the identical certificates — any fungible securities of the same issue). The lender receives the collateral back.

The borrower's motivation is typically:

• Short selling: a short seller borrows shares, sells them, hopes the price falls, buys them back cheaper, and returns them to the lender. The difference is the short seller's profit.
• Hedging: some derivatives require physical delivery of underlying securities.
• Settlement failure coverage: borrowers temporarily short of securities for delivery obligations.

The lender (your fund) earns the lending fee. This income either reduces the fund's ongoing charges or enhances its return — which is why some ETFs have ongoing charges below what seems economically viable.

How ETF managers use securities lending

Index tracker ETFs are the most prolific participants in securities lending. The typical structure:

1. The ETF manager (e.g., Blackrock iShares, Vanguard, State Street SPDR) lends securities from the fund's portfolio to approved borrowers (prime brokers, investment banks).
2. The borrower provides collateral — typically government bonds or high-quality equities — of at least 102–105 per cent of the loan value, to a third-party collateral agent.
3. The borrower pays a daily lending fee to the fund.
4. Revenues are split between the fund (the primary beneficiary) and the fund manager (for arranging the programme). Typical splits are 60–80 per cent to the fund, 20–40 per cent to the manager.

For popular ETFs tracking major indices (S&P 500, FTSE 100, MSCI World), securities lending revenues can amount to 0.01–0.10 per cent per annum — not large, but meaningful at scale and capable of more than offsetting a tracker's management fee.

For niche or illiquid indices (small-cap, emerging markets, sectors with significant short interest), lending revenues can be substantially higher — occasionally 0.5–1.5 per cent per annum — which explains why some specialist ETFs generate returns that exceed their benchmark.

Open-ended vs term lending

Open-ended (callable) loans: the most common structure. Either party can recall the securities on short notice (typically overnight or within a few days). The borrower returns the securities; the lender returns the collateral. Income accrues daily.

Term loans: fixed-duration loans (one week to several months). Higher lending fees reflect the borrower's certainty of supply. Less flexible for the lender — the fund may not be able to recall securities during the term without a contractual break clause.

Most ETF securities lending programmes use predominantly open-ended lending, with some term loans for borrowers willing to pay a premium for supply certainty.

Revenue returned to the fund

The key question for investors: how much of the lending revenue actually reaches the fund?

Revenue sharing arrangements vary by fund manager:

• Blackrock iShares: typically 62.5 per cent to the fund, 37.5 per cent to the management company (as of published policies; verify current terms).
• Vanguard: up to 100 per cent of revenues from its internally managed lending programme to the fund, as Vanguard is client-owned and does not seek external profit from the programme.
• State Street (SPDR): varied by fund; typically 70–85 per cent to the fund.
• Invesco, Amundi, HSBC Asset Management: varies; check each fund's annual report.

Each UCITS fund must disclose its securities lending revenue and revenue-sharing arrangements in its annual report and in the fund's prospectus. This information is public — if you cannot find it, request it from the fund manager.

Risks to the lender

Counterparty risk: if the borrower defaults before returning the securities, the fund needs to use the collateral to buy replacement securities. This risk is mitigated by:

• Over-collateralisation (102–105 per cent of loan value)
• Daily mark-to-market of the loan and collateral (collateral is adjusted as values move)
• Approved borrower lists (typically investment-grade banks and broker-dealers)
• Indemnification programmes offered by some ETF managers

Collateral risk: if the fund accepts equities as collateral (rather than government bonds), the collateral may fall in value simultaneously with the defaulting borrower's position — a double hit. Most institutional programmes use government bond collateral to manage this.

Reinvestment risk (cash collateral): if cash collateral is received and reinvested in money market instruments, losses on those instruments are borne by the fund. The 2008 credit crisis produced several high-profile losses from securities lending programmes that reinvested cash collateral in credit instruments that then defaulted. Post-crisis regulation has tightened permissible reinvestment strategies significantly.

Margin drag: over-collateralisation means the borrower must post more collateral than the loan is worth. For the borrower, this ties up capital. For the fund, it means holding the borrower's collateral — which may be lower-yielding than the lent securities. The difference is the margin drag, which partially offsets the lending fee.

Recall risk: if the fund calls back lent securities (to vote at a shareholder meeting, or because of a large redemption), there may be a short lag. During this period, the fund may temporarily not hold the full index exposure. For passive index trackers, this creates a small tracking error.

UCITS rules on securities lending

The UCITS Directive (applicable in the UK via retained EU law and FCA rules) governs securities lending by UCITS funds:

Limits: a UCITS fund may lend up to 100 per cent of its portfolio (in theory), but the collateral received must be sufficient to allow full reinstatement of the lent securities at any time. In practice, most UCITS programmes lend 20–50 per cent of the portfolio at any one time.

Collateral requirements: collateral must be:

• Diversified (no single issuer exposure above 20 per cent of net asset value)
• Of high quality (typically government bonds or high-grade equities from approved markets)
• Held by the fund's depositary or a sub-custodian

Disclosure: UCITS funds must disclose securities lending activity, revenue, and counterparties in their annual report and accounts. The SFTR (Securities Financing Transactions Regulation) — applicable in the UK post-Brexit — requires additional reporting on securities financing transactions.

Reinvestment: cash collateral reinvestment is subject to strict limits — UCITS may only reinvest in short-duration, high-quality instruments. Leveraged reinvestment is prohibited.

What this means for HNW private clients

For investors holding UCITS ETFs or index funds within their portfolio, securities lending is largely benign and often marginally beneficial (through fee offsets). The key due diligence questions are:

1. Does this fund engage in securities lending?
2. What percentage of lending revenue is returned to the fund (vs retained by the manager)?
3. What collateral types are accepted, and how is counterparty risk managed?
4. Is there a manager indemnification against counterparty default?

For clients with separately managed accounts (SMAs) or direct portfolios managed by a private bank, securities lending of directly held equities is less common but exists — particularly within prime brokerage-style relationships. The economic benefit (lending fee) typically flows to the client, not the bank, in a well-structured arrangement. Ensure your custody agreement makes clear whether your securities may be lent and on what terms.

Clients wishing to opt out of securities lending should raise this directly with their fund manager or custodian. For UCITS ETFs, opting out is generally not possible at the individual investor level — it is a fund-level decision. For directly held equities in a custody account, opt-out may be feasible.

How Global Investments can help

Global Investments works with HNW clients on the full spectrum of investment portfolio infrastructure, including understanding the operational mechanics — custody, securities lending, collateral management — that sit beneath their portfolio. For clients evaluating fund selection, custody arrangements, or portfolio construction, we can introduce specialist advisers and private banking relationships that provide transparent, client-aligned service structures.

Contact us to discuss your investment portfolio and whether your current arrangements are working efficiently in your interest.