Monday, January 11, 2016

Even cheaper than an ETF

John Bogle, father of passive investing

With fees as low as 0.10%, passively managed ETFs are one of the cheapest ways to get exposure to equities. Not bad, but here's a financial product that would be even cheaper for investors: an equity deposit. I figure that equity deposits would be so cost efficient that rather than charging a management fee, investors would be paid to own them.

To understand how equity deposits would work, I want to make an analogy to bank deposits. Think of an equity ETF as a chequing account and an equity deposit, or ED, as a term deposit. In the same way that chequing deposits can be offloaded on demand, an ETF can be sold whenever the owner wants, say on the New York Stock Exchange or NASDAQ. Equity deposits, like term deposits, would be locked in until their term was up up. Issued in 1-month, 3-month, 1-year, 3-year, and 5-year terms, EDs would replicate a popular equity index like the S&P 500.

Given that both ETFs and EDs track the same index, and both provide the same dividends, the sole difference between the ETF and the ED is their liquidity. A commitment by an investor to an ED is irrevocable (at least until the term is up) whereas an ETF allows one to change one's mind.  ETFs represent liquid equity exposure; EDs are illiquid equity exposure.

An investor might buy an ED rather than an ETF for the same reason that they might prefer term deposits to a chequing account; they are willing to sacrifice liquidity for a yield. For a trader with a holding period of a few minutes or hours, an ED would be an atrocious instrument. On the other end of the spectrum, long-term buy-and-hold investor would be perfect candidates for substitution from ETFs into EDs. Come hell or high water, investors following a buy and hold strategy have pre-committed themselves to owning equities till they retire. As such, they don't need the permanent liquidity window that ETFs provide. Now if that window were provided free of charge, then investors may as well buy ETFs. But liquidity doesn't come without a cost, as I'll show below. Which means that long-term investors who own ETFs are paying for a worthless feature.

Better for a buy and hold investor to slide a portion of the portfolio that has already been dedicated to ETFs into higher yielding 5-year EDs, rolling these over four or five times until they retire. In doing so, investors get a higher return while forfeiting liquidity, a property they put no value on anyways.

How is it that an ED can provide a higher return than an ETF? Here's how. Once investors' funds have been irrevocably deposited into a 5-year vehicle, the manager buys the stocks underlying the S&P 500. Next, the manager offers to lend this stock to various market participants, either short sellers looking to make a quick buck or market makers who want to replenish inventories. These loans, which are quite safe due to the fact that the borrower provides collateral, earn a recurring stream of interest income which the ED manager shares with the ED investor. This return should be high enough to more-than counterbalance management expenses such that on net, ED investors end up earning an extra 0.25% or so each year rather than paying 0.10-0.50%.

But wait a minute, why don't ETFs do the same thing? Why don't they lend stock and share the income with ETF investors? Actually, they already do. And in some cases, ETF managers are already providing investors with more in lending income than they are docking them to manage the ETF. See the screenshot below from an iShares quarterly report:

The iShares Russell 2000 ETF, which has a net asset value of around $25 billion, provided investors with $34.58 million in stock lending income in the six months ended September 30, 2015, well in excess of advisory fees of $27.85 million.

So yes, ETFs can and do earn stock lending income, but my claim is that an ED manager following an equivalent index would be able to earn even more from lending out stock. To understand why, we need to think about how stock lending works. Stock loans are usually callable, meaning that the lender, in this case the ETF, can ask for a return of lent stock whenever they want. Callability is terribly disadvantageous to the borrower, especially a short seller, as they may have to buy back and return  said stock when they least want to, say during a short squeeze. In order to protect themselves, a short seller will always prefer a non-callable stock loan, say for 1-year, then a callable one, and will be willing to pay a higher interest rate to enjoy that protection.

ETFs and mutual funds are not in the position to provide non-callable stock loans because ETF and mutual fund units can be redeemed on demand by investors. For instance, if performance lags a mutual fund manager may start to experience large redemption requests. To meet those demands, the manager needs the flexibility to recall lent stock and quickly sell it. As for ETFs, units can be redeemed when authorized participants submit them to the ETF manager in return for underlying stock. So an ETF manager is limited in their ability to lend out stock on a long term basis lest they are unable to fulfill requests from authorized participants. Because ETFs and mutual funds can only lend on a callable/short-term basis they must content themselves with a correspondingly low return on lent stock.

As one of the only actors in the equity ecosystem with a long-term pool of pre-committed stock-denominated capital, an ED manager is in the unique position of being able to make non-callable term stock loans. Put differently, redemption of EDs is distant and certain, so only an ED structure allows for the perfect matching of long term assets with long-term liabilities. This means EDs should enjoy superior stock lending revenues, more than offsetting the costs of running the ED.

Say that an ED can beat an ETF by around 0.5% a year thanks to its superior stock lending returns. That doesn't sound like much, but compounded over a long period of time it grows into a large chunk. For instance,  If you invest $2000 each year for 25 years in an ETF that earns 8%, you end up with $157,900. Place those funds in an ED that returns 8.5% and you end up with $170,700. That's a pretty big difference.

EDs don't exist. But if they did I'd probably sell a significant number of my ETFs and buy EDs. I could imagine putting 20% of my savings in a 5-year S&P 500 ED, for instance. What about you?

PS: Feel free to torture test this idea in the comments
PPS: It is very possible that this product already exists.
PPPS: The devil is in the legal details.

Related posts:

An ode to illiquid stocks for the retail investor 
A description of the moneyness market 
If your favorite holding period is forever 
Beyond Buffett: Liquidity-adjusted equity valuation 
Liquidity as static 
No eureka moment when it comes to measuring liquidity


  1. Twitter conversation;

  2. I've always been fuzzy about interest being paid on a loan of stock. The guy who borrowed the stock is already paying dividends on it, so why should he also pay interest? The guy who lent the stock is already receiving dividends, so why should he also receive interest? Or what if a trader promises future delivery of stock without currently borrowing it? Would the trader have to pay interest on his promise? Or what if A and B make a bet where A pays B $1 when the stock falls $1, while B pays A $1 when the stock rises $1? Guy A is in the same payoff position as the trader above, but I'd be very surprised if A paid interest to B.

    1. "The guy who borrowed the stock is already paying dividends on it, so why should he also pay interest? The guy who lent the stock is already receiving dividends, so why should he also receive interest?"

      Hi Mike. My thinking goes something like this. Let's say that lending is in the form of a 1-month term loan. The investor can either lend their stock and get dividends or keep the stock and get dividends. If they choose to lend, they forgo the ability to sell the stock for the term of the loan. They should be compensated for the illiquidity they have to bear, thus they receive interest. The shorter the term, the less they should be compensated.

      "Or what if A and B make a bet where A pays B $1 when the stock falls $1, while B pays A $1 when the stock rises $1? "

      No one is giving up availability of some instrument, so interest payment aren't necessary.

  3. Securities lending collateral is normally invested in something like a money market fund, which isn't quite risk-free. So there's an ambiguity about the source of securities lending income: is it actually from securities lending or is it coming from money market investing? If the latter, then it's just an opaque way of adding more systemic risk.

    With "hard to borrow" shares there's clearly real income to be made from lending. But you are even better off selling the shares rather than lending (the reason why they are hard to borrow is that they are overvalued).

    1. "If the latter, then it's just an opaque way of adding more systemic risk."

      Good point. But I think the risk begins before the collateral is invested in the money market. Even if the collateral is kept uninvested, there's still counterparty risk. The stock borrower might go broke and be unable to return the stock, and the uninvested collateral could prove insufficient to repurchase the stock in the open market if the stock price has jumped significantly.

      Both ETFs and EDs are riskier than equivalent portfolios of non-lent stock. But are EDs riskier than ETFs because their lending would be non-callable rather than callable? I'm not so sure.

      "But you are even better off selling the shares rather than lending (the reason why they are hard to borrow is that they are overvalued)."

      Yes, but if you're trying to replicate an index you can't do that.

  4. ED is a very interesting idea. I've managed hedge funds with large short books and experienced recalls on shorts when markets fall and funds flow out of the underlying fund/ETF that has lent the money. I'd expect there would be a demand for stable inventory of loanable shares from hedge funds and the prime brokers that intermediate the loans. The demand would not likely be in S&P500 names - as there is ample supply of these names and recalls are very rare. But there could be significant demand for developed Asia, emerging and frontier market names where it is very difficult to find shares to short and where recalls are frequent.

    Some funds already do exclusive stock lending deals with prime brokers where the get a certain percentage of the funds assets (say 1%) per year as a guaranteed payment in exchange for lending their stock exclusively to one prime broker. However, they still retain the right to recall the names to meet redemptions. One would think ED funds could charge even more.

    To answer Max's questions - securities lenders make money both off the stock loan fee and from reinvesting the collateral. Many of the big custodians (stock lenders) got into trouble in 2008 because they had invested the collateral in securities with credit risk that became illiquid. I'm sure some of this still goes on but I think risk management on that side of the business has been tightened

    1. Kevin, great comment.

      "The demand would not likely be in S&P500 names - as there is ample supply of these names and recalls are very rare."

      Agreed. I noticed that the iShares S&P 500 ETF only makes around 0.006%/year on stock lending. Even if an equivalent ED could make 0.02% on term loans of S&P 500 stock, that'd be peanuts compared to management expenses of 0.07% or so. But what about Russell 2000 names? That might be more fertile ground for ED funds.

    2. Yes Russell 2000 would be somewhat more fertile, but even in the smaller names there are surprisingly few recalls. Still a broader universe like the Russell 2000 would give prime brokers a stable supply of deal stocks - companies that are involved in M&A transactions. They can lend out the stocks of acquiring companies for very high rates to merger arb funds during the time it takes for deals to get completed, so I would expect they would be willing to pay something for that stable supply. I still believe the real win would be an ED in developed Asia, emerging markets or developed small caps.