By: Tom Goodwin, Senior Research Director
In a previous post, I examined the surprising historical tendency of small caps to outperform large caps in periods of slow economic growth. Given the current market climate, the small cap market segment may be worth a look. As income opportunities remain scarce, managing the costs of any investment is particularly important to optimize returns. Market participants have widely adopted securities lending strategies as a way to achieve this aim.
A highly liquid ecosystem of investment products has grown up around the small cap Russell 2000 Index since its inception in 1984. These products consist of exchange traded funds (ETFs), futures and options. The growth of ETFs which are based on the Russell 2000 has provided market participants with the ability to trade a physical security (ETF) for the purposes of hedging and shorting small cap exposures.
To hedge or short small cap exposures, the ETF must be borrowed. This has created an opportunity for those market participants holding small cap ETFs to lend out their shares for additional income. Several large institutions have successfully operated this type of “long and lend” opportunity. For example, the California Public Employees’ Retirement System (CalPERS) earned approximately $2 million in securities lending income for the 2014-2015 fiscal year.
We can see how the securities lending process works in the illustration below. An investor holding an ETF can engage in a “long and lend” strategy by lending the security to a borrower through a lending agent. In doing so, the lender will receive liquid 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 primary risks associated with this strategy are counterparty and reinvestment risk. However, these risks can be significantly mitigated through strong risk management, conservative investment guidelines, ongoing credit reviews and the daily mark-to-market of collateral.
Establishing a separate account that holds and lends an ETF based on the Russell 2000 Index, therefore, can provide market participants with an index-based exposure to small caps with the added potential for income enhancement. Through the lending agent, the market participant stands ready to respond to anyone asking, “May I borrow your small caps?”
For further insights on this subject, please see: “The Russell 2000 Index, small cap performance in a slow-growth economic environment.”
 Correspondence with Market Securities Finance.
 Comprehensive Annual Report, Fiscal Year Ended June 30, 2015, CalPERS, Nov. 2015.
 “Securities Lending Best Practices”, Securities Finance Trust Company, 2012.
© 2016 London Stock Exchange Group plc and its applicable group undertakings (the “LSE Group”). The LSE Group includes (1) FTSE International Limited (“FTSE”), (2) Frank Russell Company (“Russell”), (3) FTSE TMX Global Debt Capital Markets Inc. and FTSE TMX Global Debt Capital Markets Limited (together, “FTSE TMX”) and (4) MTSNext Limited (“MTSNext”). All rights reserved.
FTSE Russell® is a trading name of FTSE, Russell, FTSE TMX and MTS Next Limited. “FTSE®”, “Russell®”, “FTSE Russell®” “MTS®”, “FTSE TMX®”, “FTSE4Good®” and “ICB®” and all other trademarks and service marks used herein (whether registered or unregistered) are trade marks and/or service marks owned or licensed by the applicable member of the LSE Group or their respective licensors and are owned, or used under licence, by FTSE, Russell, MTSNext, or FTSE TMX.
All information is provided for information purposes only. Every effort is made to ensure that all information given in this publication is accurate, but no responsibility or liability can be accepted by any member of the LSE Group nor their respective directors, officers, employees, partners or licensors for any errors or for any loss from use of this publication or any of the information or data contained herein.
No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the results to be obtained from the use of the FTSE Russell indexes or the fitness or suitability of the indexes for any particular purpose to which they might be put.
No member of the LSE Group nor their respective directors, officers, employees, partners or licensors provide investment advice and nothing in this communication should be taken as constituting financial or investment advice. No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any representation regarding the advisability of investing in any asset. A decision to invest in any such asset should not be made in reliance on any information herein. Indexes cannot be invested in directly. Inclusion of an asset in an index is not a recommendation to buy, sell or hold that asset. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.
No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the applicable member of the LSE Group. Use and distribution of the LSE Group index data and the use of their data to create financial products require a license from FTSE, Russell, FTSE TMX, MTSNext and/or their respective licensors.