How ETF Securities Lending Revenue Offsets Costs

An ETF can lend its portfolio holdings—stocks, bonds, or other securities—to short sellers and other borrowers, and collect fees for that loan. Those fees flow back to the fund, which uses them to offset operating costs and, in many cases, reduces the net expense ratio investors pay. It is a material but often overlooked source of income for fund managers.

How Securities Lending Works in an ETF

When a portfolio manager holds 1,000 shares of Apple stock in an ETF, those shares sit in custodial accounts and generate no income on their own—they merely appreciate or depreciate. But those shares have economic value to others. A short seller who wants to short Apple stock must borrow shares to deliver to the buyer. A market maker managing inventory in a thinly traded bond might borrow specific issues temporarily. For both, paying a borrowing fee is cheaper than the alternative: going without.

An ETF manager can, with appropriate safeguards, lend those shares to a borrower. The borrower posts collateral—usually cash or Treasury securities worth more than the loaned shares, typically 102–105% of market value to absorb price moves. The ETF collects a lending fee, agreed upfront, for the loan term (which might be overnight to several months). That fee is the ETF’s revenue. After paying a portion to the custodian (who administers the loan) and any other operational costs, the remainder is returned to the fund and credited to shareholders proportionally.

The beauty of this arrangement, from an investor’s perspective, is that the fund still owns the securities. The borrower has no voting rights and cannot sell them; the custodian holds replacement collateral in case the borrower fails. The fund retains dividend and interest income, and retains voting rights. The only new variable is the lending fee revenue, which reduces the net cost of holding the fund.

Where the Money Comes From

The borrowing fee depends on how urgently the security is needed and how scarce it is. If a stock has just reported terrible earnings and is heavily shorted, the fee to borrow it can spike because many traders want it and few shares are available for loan. A stock with light short interest and abundant loanable supply might trade at minimal or near-zero borrowing cost. The same dynamic applies to bonds: a callable bond in tight supply can command high borrowing rates, while a widely held Treasury is nearly free.

The ETF manager sets the lending fee in negotiation with the borrower, or in practice often through a lending agent or custodian who auctions shares to borrowers. The fees are split: the ETF takes the majority (perhaps 75–90% depending on the arrangement), the custodian takes a portion (10–25%), and a small cut might go to a lending agent if one is involved. This split reflects the custodian’s and agent’s roles in tracking collateral, managing recalls, and handling operational compliance.

Impact on Expense Ratios

For investors, the financial result is direct: higher lending income means lower net costs. An ETF with a stated expense ratio of 0.08% might actually cost investors 0.06% after accounting for securities lending income. A large, widely shorted fund might realize even larger offsets. Conversely, a fund with no lending activity (perhaps small or specialized securities with little borrowing demand) gets the full expense ratio, with no offset.

This matters because expense ratios are often the headline measure investors use to compare funds. Two ETFs tracking the same index might both advertise 0.04% expense ratios, but if one lends actively and the other doesn’t, the actual cost to the investor diverges. The SEC now requires funds to disclose “net” expense ratios that incorporate these offsets, making the comparison transparent. But the offset is not guaranteed year to year; it depends on market conditions and borrowing demand.

In bull markets and low-volatility periods, short interest is low, and lending fees are depressed. The offset shrinks. In bear markets and periods of elevated volatility, short interest surges, and fees spike. The offset expands. This creates a counterintuitive dynamic: the higher the market turmoil, the lower the effective cost of your ETF, because more traders are hedging with shorts and paying lending fees.

Who Benefits Most From Securities Lending

Large, popular index funds benefit most. A $100 billion SPY ETF (tracking the S&P 500) holds thousands of widely held stocks that are constantly borrowed for hedging and trading. The sheer supply of loanable securities means the fund is rarely without active lending activity. The cumulative revenue, though each individual loan generates a modest fee, accumulates to millions or tens of millions per year.

Smaller, specialized funds see less benefit. A small thematic ETF holding niche companies might have few securities of interest to short sellers, or borrowers might find the supply too limited to borrow from a single fund. The lending revenue approaches zero, and the expense ratio reflects the full management cost.

Equity ETFs see more lending activity than bond ETFs, on average, because equity short selling is more common. But corporate bond ETFs, especially those holding callable or specialized bonds, sometimes achieve substantial lending revenue. Treasury funds rarely benefit, since Treasury securities are abundantly available and cheap to borrow through other channels.

Risks and Operational Complexities

Securities lending introduces operational complexity and a layer of counterparty risk, though both are usually well-managed. If a borrower fails—say, a financial institution goes bankrupt—the collateral is meant to cover the fund’s loss. But if the security has moved sharply in price, or if collateral itself declines (e.g., corporate debt issued by the failed borrower), a gap can open. This is rare in practice, especially for large institutions lending through custodians, but it is a real risk.

Regulations exist to mitigate it. The SEC requires that collateral be marked to market daily, that amounts equal at least 100% (usually 102–105%) of loaned security value, and that funds employ independent agents to monitor lending activities. Custodians are typically large, well-capitalized institutions with their own risk controls. Still, a fund prospectus will disclose the lending program and invite investors to review risks.

From an operational standpoint, lending programs require staff, systems, and custodial support that smaller or less-resourced managers might not be equipped to handle effectively. This is one reason that large fund families benefit disproportionately—they have the scale and infrastructure to manage lending profitably.

When Lending Revenue Disappears

In periods when borrowing demand collapses, lending revenue can vanish almost entirely. During the COVID-19 crash of March 2020, short interest in many stocks fell as traders unwound hedges, and lending fees compressed to near zero for days. Investors who expected steady 0.02% offsets found them gone overnight. Similarly, if the SEC or another regulator proposed restrictions on short selling or securities lending, fund revenue would decline, and expense ratios would effectively rise (without the ratio itself changing).

Some funds also choose to restrict or stop lending for reputational or policy reasons. A fund manager might decide that the operational or reputational cost of facilitating short selling outweighs the modest fee income. This is an outlier position, but a few environmentally or socially focused funds have adopted such policies.

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