Catherine Yoshimoto
After years of strong returns, 2022 was the worst year for global equities since the 2008 financial crisis. As bullish sentiments faded, many investors returned to short-selling strategies.
This trend is evident in the recent increase in securities lending activity, the mechanism which enables short selling. In 2022, large institutional investors earned a total of $12.5 billion in securities lending revenues - representing a 15% increase from the previous year.[1] The California Public Employees’ Retirement System (CalPERS) is an example of a large institution that has successfully implemented a long and lend strategy, earning nearly $1 million in securities lending income for the 2021-22 fiscal year.[2]
As more market participants sought to short securities in today’s volatile markets, small cap Russell 2000 ETF liquidity has again given rise to securities lending opportunities that have offered the potential to enhance passive investment returns.
The mechanics of this “long and lend” strategy is illustrated below. As shown, the lender receives cash collateral plus a premium for the duration of the loan. The lender benefits from the premium paid over the value of the ETF, plus any income generated when the collateral is reinvested.
The mechanics of securities lending
Source: FTSE Russell.
The primary risks associated with this strategy are counterparty and reinvestment risk. However, these risks can be significantly mitigated through conservative investment guidelines, ongoing credit reviews, and marking collateral to market daily.
May I borrow your small caps?
When the Russell 2000 was launched in 1984, it was the first index designed to measure the US small cap market segment. Market participants have since overwhelmingly embraced the Russell 2000 - not only as a benchmark for the small cap market with 92% of US small cap fund products and 83% based on assets benchmarked[3] - but also as the basis for passive investment products such as ETFs.
As such, Russell 2000 ETFs have emerged as powerful tools for shorting or hedging small cap exposures - a process that requires borrowing the ETF. On the other side of this equation, an investor holding the ETF can lend the security to the borrower through a lending agent.
Among these products, ETFs tracking the Russell 2000 have seen exceptionally high liquidity, making them a popular vehicle for shorting the small cap market segment. This presents an opportunity for market participants to potentially enhance passive investment returns with the long and lend strategy - particularly in today’s volatile markets. In December 2022 alone, the iShares Russell 2000 ETF (IWM) was the highest revenue generator among US ETFs, generating $1.64 million in securities lending revenues.[4]
For more details about trends in across global asset classes, see our latest Performance Insights.
[1] Source: S&P Global Market Intelligence, 2022
[2] Source: CALPERS Annual Comprehensive Financial Report, June 2022
[3] Source: Data as of December 31, 2021 as reported on April 1, 2022 by eVestment for active institutional funds, Morningstar for active retail mutual funds, insurance products, and ETFs, and passive assets directly collected by FTSE Russell. AUM includes blended benchmarks and excludes futures and options. AUM data does not include active and passive assets not reported to a 3rd party source or FTSE Russell. For funds where the AUM was not reported as of December 31, 2021, the previous period AUM was used as an estimate. No assurances are given by FTSE Russell as to the accuracy of the data.
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