In the June issue of Securities Lending Times, Simon Colvin of IHS Markit reports on the growing passive funds market and its utilization of securities lending and borrowing. According to Colvin, two-thirds of the global securities lending inventory is now associated with passive funds. These funds have been significantly growing in assets under management and also significantly increasing their utilization of the securities finance market. This trend in passive funds securing lending has been specifically evident as passive fund securities lending inventory has growing from only half in 2008 to its current level of approximately two-thirds.
Passive Funds and Securities Lending and Borrowing
Passive funds have been significantly growing, reporting four times the growth in comparison to active funds since 2007. Since 2007, these funds have reportedly grown by 230% to a total asset value of $6 trillion. Assets in active funds still significantly outsize passive funds at $24 trillion however since 2007 these funds have only grown assets by 54%. A number of factors have influenced greater interest in passive funds including low interest rates, high active management fees, and lower tolerance for risk and performance volatility.
Market speculators believe the trend in passive investing will continue and one factor adding to the attractiveness of the funds is their successful use of securities lending and borrowing. In the fund management industry, securities lending and borrowing within passive funds has outperformed its comparable active funds by 14% reporting a three-year average annual return of 0.051% versus 0.045% by active funds. According to Colvin, one main difference for the outperformance is that passive funds have broader provisions for collateral in securities finance transactions.
Collateral Acceptance by Passive Funds
In securities lending and borrowing transactions, lenders can accept cash collateral or a wide range of non-cash securities. Individual markets have different requirements for acceptable securities beyond cash. Government bonds are typically the most favored collateral asset. Passive funds have been able to historically outperform other categories by agreeing to broader collateral standards and accepting lower credit quality assets. In the current market, approximately 80% of passive funds are reporting fund management provisions that allow for lower credit quality assets with G10 bonds and equities eligible as securities finance collateral. In comparison, active funds have reported much higher securities finance collateral requirements, with 36% of funds accepting only G7 bonds.
Industry Trends in Securities Lending and Borrowing
Colvin also reports on industry trends supporting the successful performance of securities lending and borrowing in passive funds. Such trends include an oversupply of securities giving lenders greater authority over the quality of securities they lend and new derivatives clearing regulations changing internal collateral management. These trends have created opportunities for lenders to lend high quality assets in exchange for lower quality collateral. European sovereign bonds represent one example of this trend as they have been increasingly willing to lend bonds with lower credit quality collateral requirements thus providing greater opportunity for return. The lending of these securities has greatly benefited passive fund investments while also providing greater returns for lenders. Passive funds have been able to engage in a broader range of securities lending and borrowing transactions because they have less stringent collateral credit quality requirements.
Passive Funds Growing in Market Significance
Overall, passive funds have been steadily growing their market significance and as of 2016 represent approximately 30% of total assets in the US. Reporting a growth rate of 230% since 2007 their assets totaled $6 trillion in 2016. Market factors expect to support continuation of this trend as investors are moving away from high active management fees. Securities lending and borrowing in passive funds adds another reason for increased interest in the investments as the funds’ securities finance returns outpace those of active funds. Passive fund managers expect to continue utilizing their investment management approach for securities finance which allows for a broader range of collateral in securities finance transactions leading to higher returns. Active fund managers have not reported any loosening in the terms of collateral for their funds signifying that securities lending and borrowing outperformance is expected to continue, adding an additional element of outperformance overall for passive funds.
