With the October market frailties seemingly safely behind us, now might be the right time to look at some ‘what-if’ speculation for how passive investors might behave if a sell-off took on more dangerous proportions than those witnessed in October.
One piece of research that caught the eye came from the global quantitative strategy analyst team at Bernstein led by Inigo Fraser-Jenkins that came out mid-turbulence last month.
He and his team focuses on the issue of security lending – the practice of offering shares accumulated by a passive fund in order to gain income from the lending fee charged.
It is a process which has boomed alongside the massive growth in passive assets under management – and in recent months in particular it has taken a further leap upwards.
The Bernstein team quotes statistics from the International Securities Lending Association (ISLA) that shows the amount of securities out on loan in June 2018 reached €2.1trn, an increase by 8% from six months earlier. Meanwhile the total stock of securities available to be loaned also rose by 8% to €17.4trn. As we shall see, this is potentially an important indicator.
The reason for this strong growth in securities lending is, Fraser-Jenkins’ team suggest, directly correlated to the drive towards lower fees, particularly in the passive universe. The Bernstein team calculates that the fees gained from securities lending amount to between 30-40 basis points annually. It’s not much but when – as most ETFs do – the money is pumped back into the fund, it can effectively mean that given the fees that are charged these days, investors are getting the fund for nothing.
Yet much as this might appear like the proverbial gift horse, the team actually suggest this income stream should be considered as a risk premia rather than as an income stream to offset fees.
This is for the obvious reason that the borrower could go bankrupt. This isn’t far-fetched scenario, given that the borrowers of most of this lent securities is likely to be a hedge fund.
Setting aside what Bernstein suggest are the ethical dimensions of a passive fund lending stock to a fund which is likely shoring one of the fund’s constituents (one for a Radio 4 panel show rather than for a site like ETF Stream), the issue is that hedge funds do sometimes go bust.
Obviously this most often occurs in times of market stress. Should a big hedgie go belly up in some future storm, what becomes of the passive fund which lent the find its collateral? There are, as Fraser-Jenkins and the team write, financial stability policy implications.
“If a stressed situation led to borrowers of stock going bankrupt and a mismatch of collateral then the price of a passive fund could diverge from the index it is supposed to track,” they write. “The question here is would this shake the confidence in passive products?”
As the Bernstein team are keen to point out, this might seem like a vague prospect bt it needs to be considered. Indeed, as opposed to the scares and alarums that have been broadcast by figures who should know better and would seem more concerned that an ETF is an acronym just like all those other three-letter acronyms that brought down the financial house of cards 10 years ago, this is an actual fear that should be addressed.
“To be clear, we are not forecasting an aggressive sell-off in capital markets as being likely in the short-term,” says Fraser-Jenkins et al. “Yet the role of passive in such an environment is untested as in the great financial crisis the AUM of passive was insignificant.”
The key questions, then, are what will be the attitude of investors in ETF products when prices fall sharply. Are they more likely to redeem than investors in active funds? Does the reduction in number of active funds which are able to step in to buy distressed assets create a risk of greater instability? And finally – and this might be the big one – would any mismatch between ETF prices and the underlying index further accentuate the pressure to redeem such products in a time of market stress?
These are, for now, somewhat unanswerable questions. But it can also be argued that these questions might not in the end be tested in real-life conditions. As Bernstein argues, there is a supply and demand dynamic taking place that could mean that the income from lending might be on the decline with the increase in passive AUM meaning that there is an oversupply of assets.
But Oliver Smith, head of smart portfolios at IG Group, disagrees, suggesting that demand will remain.
“Is the increasing market share of ETFs and index funds going to result in downwards pressure on lending revenue? Possibly. But securities lending is a function of both supply and demand, demand being dictated by market conditions.
Most of the growth in passive products has come from active fund AUM. Those funds have securities lending progammes, managed by their custodians who are financially incentivised to make extra revenue, meaning that competition to lend stock has not necessarily been diminished as much as the authors fear.”