Securities lending

Securities lending is a practice where a fund temporarily lends out the stocks or bonds it holds in its portfolio to another party, most commonly a short seller who needs to borrow shares to execute a short sale, in exchange for a fee. The fund retains economic ownership of the securities throughout the loan, including the right to any dividends or interest paid, and the borrower is required to post collateral, typically cash or high quality securities worth more than the value of what was borrowed, to protect the fund if the borrower fails to return the shares.

Many index funds and ETFs run securities lending programs as a way to generate a small amount of extra income on top of the returns from the securities they already hold, since a large diversified fund often has plenty of shares sitting in the portfolio that are not otherwise being actively traded. That extra income can help offset a portion of the fund's expense ratio, effectively lowering the fund's true net cost to investors below its stated headline fee.

Securities lending is not without risk. There is a small chance the borrower defaults and the posted collateral turns out to be insufficient or difficult to liquidate quickly, and lent out shares can sometimes complicate an investor's ability to receive certain tax treatment on dividends paid during the loan period. Regulators require funds to disclose their securities lending practices and how any resulting income is shared between the fund and its manager, which is worth checking for anyone curious about how much of a fund's actual return comes from sources beyond just holding its stated portfolio.