If the ETF market's phenomenal growth can be attributed to the typical fund's ability to offer low-cost access to a diversified pool of securities, then the ability to do this rests on quite complicated underlying mechanics. That includes, of course, the in-kind creation/redemption process, which involves the fund provider and a series of market makers/Authorised Participants, and contributes greatly to the overall low costs of ETF portfolios.

No less important in keeping ETF costs competitive and the secondary market liquid is the securities lending process, both within ETFs and at the fund level. Securities lending is the flip side of the short sale market. The way it works is simple. In order to sell shares in an ETF or a stock short, an investor must first "borrow" them from another shareholder. The borrower typically pays a fee to the shareholder loaning the shares. This fee varies based on the scarcity of the loaned security: A commonly held share can be borrowed for very little, while a more esoteric security (or a security that a lot of people are trying to sell short) may cost more. Lending securities can be a very lucrative endeavour for investors.

In the ETF world, there are two kinds of securities lending that take place: securities lending within an ETF and securities lending of ETFs. Within an ETF, the ETF sponsor can loan out shares of the underlying stocks held by the ETF, e.g., a FTSE 100 ETF could loan shares of the underlying FTSE 100 components. These fees can be (but are not always) used to augment the total return of the fund.

The lending of ETF shares themselves is completely different, offering ETF shareholders the chance to profit from their funds in an important way.

In this article, I concentrate on lending of ETFs, rather than the income from the lending of funds' underlying securities (i.e., lending within ETFs), a subject I hope to refer to in a future article.

U.S. Vs. Europe

One of the major differences between the U.S. and European ETF markets is the extent to which securities lending is much less developed as an activity in Europe than across the Atlantic. The charts below, provided by the London-based securities finance specialists, Data Explorers, show the average percentage utilisation (i.e., the proportion of the available supply of ETFs on loan at any given time) in the U.S. and Europe respectively. Note the different y-axis scales in the two charts.

Source: Data Explorers

So while in the U.S. nearly half of the available supply of ETFs is typically on loan at any time, in Europe the percentage has been in single figures, and recently in the low single figures.

Data Explorers also provided figures for the percentage on loan of the largest 10 European equity ETFs, taking a snapshot a couple of weeks ago, and they found that only two of the top 10 had lending levels above 1%—the Lyxor and BGI versions of the DJ Euro Stoxx 50 ETF, at 3% and 1%, respectively.

Why is this? What accounts for the relatively low lending activity in Europe? After all, it is frequently pointed out by market observers that ETF lending revenues can frequently cover the total expense ratio, making the investment effectively cost-free.

Donato Cianciaruso and Stefan Kaiser of iShares, the leading European ETF provider, and one of the most active lenders of securities worldwide (both as iShares and in the guise of their parent company, BGI), gave me several reasons when I asked them this question.

First, said Cianciaruso, one must take into account that the European ETF market is at an earlier stage of development than the U.S. market, and that Europe is not a single region, either from the perspective of the issuer or from that of the investor. For example, iShares typically lists ETFs in six or seven European countries, each with different legal and tax regimes. If owners of assets are taxed at different rates in different European countries, then it may be impossible to quote a single European loan rate for individual securities.

Second, the European custody market is relatively fragmented, and many ETFs in the region are not available to loan for the reason that they have simply not been allocated to the lendable pool of securities by their custodians.

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