Index funds & ETFs
How to evaluate ETF lending and securities financing activities and their potential contribution to fund yield and operational risk.
This article explains how ETF lending programs work, what they aim to achieve for fund yields, and which operational risks investors should consider when evaluating such programs within index funds and ETFs.
Published by
Paul Johnson
July 23, 2025 - 3 min Read
Over the past decade, exchange traded funds have increasingly implemented securities lending and financing programs as a way to enhance yields without directly increasing management fees. These activities involve temporarily transferring ownership of a subset of a fund’s securities to borrowers, typically in exchange for collateral and a fee. The structure is designed to be passive for the investor, with the fund manager monitoring counterparty risk, collateral quality, and lending terms. While lending can boost aggregate returns, it also introduces exposure to operational processes like collateral management and governance oversight. Understanding the mechanics helps an investor weigh potential yield benefits against the complexity and risk of administration.
When assessing an ETF’s lending framework, the first step is to clarify who bears the risk in the lending chain. The fund retains overall responsibility for the loan program, including ensuring collateral remains sufficient and that borrowers meet credit standards. The second step is to examine collateral arrangements: typically, high-quality collateral is pledged, often cash or government securities, to mitigate credit risk. Managers may reinvest cash collateral, which introduces liquidity and market risk. Transparency about collateral types, re-investment policies, and collateral reuse is essential so investors can gauge how much of the yield comes from lending activity versus other fund operations or market movements.
Measuring yield contribution and risk exposure from lending activities
A robust governance framework is a prerequisite for prudent securities lending. The fund’s board or a dedicated risk committee should oversee program design, eligibility criteria for borrowers, and daily operational controls. Key documents include the securities lending policy, disclosures about potential conflicts of interest, and clear metrics for performance attribution. Investors should look for independent oversight of third-party agents who administer loans, manage collateral, and execute reinvestment strategies. Regular reporting on loan activity, collateral quality, and borrower concentration helps maintain accountability. A transparent governance structure strengthens trust that the program serves long-term fund objectives rather than short-term yield chasing.
Operational risk in lending programs hinges on timing, custody, and collateral settlement. Delays in return of lent securities or mismatches in collateral can create liquidity strains, especially during market stress. Reconciliation processes between the fund, custodian, and lending agent must be reliable and timely. The more complex the reinvestment of cash collateral, the higher the potential for operational glitches or market-driven losses. Firms that publish independent third-party risk assessments and provide daily collateral dashboards tend to offer clearer insight into the health of the program. Investors should demand these safeguards to minimize the chance that operational failures erode the intended benefits of lending.
Transparency and disclosure across lending programs
The yield uplift from securities lending is typically modest and varies with market liquidity, loan demand, and collateral terms. It is important to separate the core fund yield from the incremental income generated by lending, so investors can estimate the true incremental contribution. Some funds explicitly disclose a portion of their overall return attributable to lending, while others embed it within the gross yield calculation. Analyzing historical loan ratios and collateral mix provides a sense of how sensitive the yield is to changing market conditions. When assessing these numbers, consider how much of the yield is guaranteed by collateral and how much could fluctuate with reinvestment strategies.
Risk considerations extend beyond potential gains. Lending introduces counterparty risk, which is the possibility that a borrower cannot return the securities or that a reinvested cash collateral loses value. Liquidity risk can also arise if the lent position cannot be promptly recalled, particularly in stressed markets. Additionally, there is governance risk if the loan program’s terms are not fully aligned with the fund’s stated investment policy. To manage these risks, prudent funds establish strict eligibility criteria for borrowers, limit exposure to any single counterparty, and maintain contingency plans for rapid recall of assets during market upheaval. Investors should review these safeguards as part of their due diligence.
How lending programs affect operational risk management
Transparency is essential for investor confidence in lending programs. Clear disclosures should include the program’s objective, the expected yield contribution, and the expected range of collateral treatments. Many funds publish quarterly loan activity statistics, including total loans outstanding, average loan duration, and borrower concentration. The counterparties involved, third-party lending agents, and the custodian roles should be identifiable to investors. When disclosure is comprehensive, it becomes easier to surgically separate the impact of securities lending from core index tracking performance. Clear information about the credit quality of borrowers and the liquidity characteristics of reinvested collateral supports robust scrutiny by analysts and sophisticated investors alike.
Another layer of transparency concerns the criteria used to select reinvestment assets for cash collateral. Reinvestment choices influence liquidity, credit risk, and potential negative effects on the fund’s stated risk profile. Some programs favor high-quality, liquid assets with transparent pricing, while others pursue additional yield through diversified reinvestment strategies. Investors should verify that reinvestment risk is managed within pre-defined limits and that the fund’s policy on collateral re-use is compatible with its risk tolerance. Detailed disclosures about reinvestment procedures, liquidity buffers, and stress test results help illuminate how resilient the program would be during market stress.
Practical steps for evaluating a fund’s lending program
The operational footprint of a securities lending program includes governance, technology, and personnel commitments. Firms must maintain rigorous data systems for real-time monitoring, reconciliation, and exception handling. The technology stack should support automated alerts for collateral shortfalls, recall requests, and borrower credit events. Human oversight remains crucial to interpret anomalies, adjust exposure, and ensure policy alignment. A well-resourced program invests in staff training, robust incident response plans, and independent audits. Investors benefit when operations are designed to minimize manual intervention, reduce error rates, and provide auditable trails that demonstrate consistent adherence to policy.
Risk management also hinges on integration with the fund’s broader risk framework. Securities lending is not a stand-alone strategy; it interacts with liquidity risk, counterparty risk, and regulatory considerations. A coordinated approach ensures that changes in loan activity do not disproportionately affect the fund’s liquidity buffers or benchmark tracking. Clear escalation procedures, scenario analyses, and governance reviews help maintain discipline. In practice, funds that embed lending risk into their enterprise risk management program tend to exhibit more stable yields and clearer explanations for investors about how the program contributes to or detracts from risk-adjusted performance.
For investors evaluating an ETF’s lending program, begin with the policy document and the fund’s disclosures about counterparty risk, collateral treatment, and recall rights. Compare the stated yield contribution with independent benchmarks or peer funds to gauge relative performance. Consider the quality and transparency of third-party oversight, such as the lending agent and custodian. Assess the fund’s concentration limits and whether they are coupled with robust recall mechanisms. It is also helpful to review historical episodes of market stress to observe how the program performed in practice. A disciplined, well-documented approach leads to more informed investment decisions regarding the net benefit of securities lending.
In practice, a thoughtful evaluation balances potential yield against the additional operational and governance commitments. Investors should seek funds that publish clear, recurring updates on collateral quality, loan supply, and risk metrics. A strong program will demonstrate conservative risk controls, disciplined reinvestment choices, and transparent incident reporting. While securities lending can add incremental income, it should not come at the expense of fundamental index tracking fidelity or liquidity safety. By applying consistent due diligence across governance, transparency, and operational risk, an investor can determine whether a fund’s lending activities align with long-term goals and risk tolerance.
