Find out more about choosing the right index and approaches to securities lending.
Let’s take a look at indexing in more detail.
Some indices include securities that are not freely available to trade.
Others have so many securities it is not possible to purchase each and every one.
Choosing such an index will result in higher trading costs for the investor.
However there are indices that exclude these types of burdensome security, called Float Adjusted Indices.
As it can sometimes be prohibitive to purchase ALL the securities in an index, it is worth considering the different methods in which a fund replicates an index.
Traditionally (and ideally) a fund buys all the securities in an index – this is an example of Full Physical Replication.
For hard to replicate indices, a fund uses an Optimised Physical Replication method. The fund buys a sub-set of securities that seeks to match the risk and the return of the specific index.
Note this is a skilled task for the Fund Manager and often involves sophisticated computer models. Both replication methods aim to track the index with the lowest tracking error and deviation possible.
Whereas the tracking error measures the fund’s consistency over time, the Excess Return is a measure of the fund’s performance against a benchmark and is of greater interest to investors seeking Total Return.
Like other types of fund, an ETF may have a securities lending programme.
The Fund loans out securities to another party and in return receives cash collateral.
The Fund can then reinvest this collateral in order to generate further income for investors.
Securities lending can be beneficial to investors, as it has the potential to increase return, as long as it’s carefully risk managed.
There are 2 forms of potential risk. The first occurs if the borrower (or counterparty as they are called) collapses while holding the loaned securities. This is known as Counterparty Risk.
The second is Reinvestment risk, which occurs if the reinvestment of the cash collateral is ill considered or overly risky, resulting in lower returns of income.
It is important to ensure that the reinvestments are high quality liquid investments.
An ETF’s approach to securities lending therefore has an influence on the fund’s risk profile.
There are 2 approaches. The Volume Approach loans out a high volume of easily accessible securities, but then re-invests the collateral in high risk investment pools.
The Value Approach loans out only the high value, scarcer securities, and then reinvests the collateral in lower risk investments such as money market securities.
The Value Approach appears to have a greater reward vs risk trade off, but careful consideration is required.