• An effective securities lending programme can help to meaningfully offset fund expenses for investors, while mitigating against potential risks.
• How a fund provider approaches securities lending can reflect the firm’s overall philosophy – at Vanguard, that means giving investors the best chance for investment success. 
• A recent Morningstar study¹ ranked Vanguard first among 10 major fund sponsors in terms of the proportion of revenue from securities lending returned to fund shareholders.

What is securities lending?

Securities lending is a common practice among asset managers through which they lend certain securities from their portfolios to generate additional revenues. Asset managers that conduct securities lending programmes typically lend the securities to counterparties such as banks and broker-dealers, whose clients in turn use the borrowed securities for short selling or other strategies such as market-making, which helps contribute to market liquidity. Securities lending can be done using the holdings of ETFs and mutual funds, both active and index, as well as other types of funds.

In exchange, the lending asset manager gets a fee and collateral. While cash collateral is more common in the US, in Europe the preference is typically for non-cash collateral. And although the revenue from securities lending tends to be modest, an effective securities lending programme can generate additional income for fund investors that meaningfully offsets a fund’s expense ratio. Lending revenue becomes a more prominent differentiator as operating expenses continue to fall, due largely to “the Vanguard effect”².

Vanguard’s approach to securities lending

Vanguard’s securities lending programme is grounded in conservative principles and robust risk management controls. We seek to maximise shareholder returns while safeguarding our investors from the associated risks and give them the best chance for investment success. Our policy is to return all securities lending revenue, net of the expenses incurred in running the programme, to our funds and, ultimately, to the fund shareholders. We believe this creates a clear alignment of risk and reward and is in the best interest of investors. Vanguard doesn’t retain any revenues from securities lending. 

We keep securities lending programme expenses low (around 3%), so about 97% of the gross revenue goes to the fund shareholders. This is a fairly uncommon approach, as some asset managers keep upward of 19% of gross revenue for themselves to generate income for the company, known as a “fee split”. We believe that since fund shareholders are bearing 100% of the risk of lending securities (which we explore below), they should get 100% of the profits, net of costs.

Quality, not quantity

Only a small percentage of our portfolios is ever out on loan. Securities lending levels typically represent low-single-digit percentages of Vanguard funds’ net asset value (NAV), thus limiting our risk exposure. This is because we take a “value approach” to lending, as opposed to a volume-based approach. 

Value lending essentially focuses on quality rather than quantity. Through the value approach, we lend out securities that are in short supply and, therefore, demand a premium from borrowers. We combine this value approach, where we have fewer securities out on loan versus a quantity approach, with a conservative collateral investment that still generates reasonable interest. The end result is that investors get more attractive risk-adjusted returns than with a volume-based approach.

Volume lending, on the other hand, entails lending lower-margin securities that require higher lending volumes or riskier collateral investments to generate only moderately more net revenue. Overall, it means higher exposure and lower liquidity in the event of counterparty default. 

Vanguard only lends equities, not bonds. The equities we lend are usually small- or mid-cap stocks, or international (i.e., excluding US) stocks. These types of equities are in shorter supply than large-cap US stocks and therefore we can achieve a higher premium for lending them. Lending bonds typically carries greater complexity and cost than lending equity securities, and we currently believe any value generated from the practice would be minimal for investors. That said, we don’t rule out the possibility of revisiting fixed income securities lending in the future if the risk-reward dynamics become more favourable for our investors.

Leading the industry in putting investors first

Compared with industry peers, Vanguard stands apart in terms of passing securities lending revenue on to investors and offsetting fund expenses. A recent study from Morningstar ranked Vanguard first among 10 major fund sponsors regarding the percentage of revenue from securities lending that gets returned to fund shareholders. Through our approach to securities lending, which seeks to minimise costs and maximise the benefits, we have been able to pass 97% of revenues on to investors in our funds³.

It is important to note that Vanguard does not typically generate the highest return from securities lending compared with industry peers. This stems in part from the fact that we take a more conservative approach. That said, proceeds from Vanguard’s securities lending programme offset an average of 16% of our fees from 2018 through 2022, which leads the industry for that period⁴. This relatively high percentage stems from the fact that Vanguard returns almost all securities lending revenue to investors coupled with the typically low fees of our products.

Risks involved with securities lending

The risks associated with well-funded securities lending are low, but they do exist. One is that the borrower cannot return the borrowed securities, for example. However, we mitigate that risk by requiring our loans to be overcollateralised (i.e., the loan is backed by more collateral than it is worth). There is also operational risk, which can arise from inadequate operational or procedural controls. Another risk is the lender losing money when reinvesting the collateral – which is what happened with a few firms during the global financial crisis. 

The investment industry has evolved significantly since that crisis. There is greater regulation around securities lending and firms have improved their approaches. That said, risk cannot be completely removed. At Vanguard, our securities lending team follows a disciplined, structured and controlled approach to lending. This includes strict operational parameters and strong management oversight to ensure proper stewardship of shareholder assets, to mitigate against the various risks associated with securities lending. For example, borrowers are independently approved by Vanguard’s Fixed Income Credit Research Group and credit limits are established. The Risk Management Group monitors the usage of each credit limit on a daily basis.

¹ An Inside Look at Securities Lending: An additional source of return (and risk) for fundholders, Morningstar, August 2023.

² The Vanguard effect was a phrase coined by Morningstar in 2009 to describe the tendency of asset managers to reduce their fees after Vanguard has entered a market or introduced products in a certain category.

³ An Inside Look at Securities Lending: An additional source of return (and risk) for fundholders, Morningstar, August 2023.

⁴ An Inside Look at Securities Lending: An additional source of return (and risk) for fundholders, Morningstar, August 2023.

Investment risk information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

ETF shares can be bought or sold only through a broker. Investing in ETFs entails stockbroker commission and a bid- offer spread which should be considered fully before investing.

Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.

Important information

For professional investors only (as defined under the MiFID II Directive) investing for their own account (including management companies (fund of funds) and professional clients investing on behalf of their discretionary clients). In Switzerland for professional investors only. Not to be distributed to the public.

The information contained herein is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information does not constitute legal, tax, or investment advice. You must not, therefore, rely on it when making any investment decisions.

The information contained herein is for educational purposes only and is not a recommendation or solicitation to buy or sell investments.

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