Securities lending with ESG ETFs is currently a no-go zone for issuers amid concerns of reputational damage and collateral problems, however, with steps being taken by lenders to integrate ESG factors into its programmes, is there any scope for change?
Securities lending in ETFs has almost doubled since 2017, according to data from EquiLend, with ETF on-loan value jumping 76.9% to $66.3m. However, this growth has been behind the rise of ETFs with assets increasing 93.7% to $9.2trn.
ETF securities lending has been off-the-pace over the past few years due to the phenomena of ESG and the dramatic growth of the sustainable investing. With the boom in ESG ETF launches in Europe over the past few years, issuers have been resistant to lend out the underlying securities of these strategies even amid the lure of basis point savings.
Highlighting this resistance, when DWS switched the underlying index of its UK ETF last December from the FTSE All-Share to the MSCI UK IMI Low Carbon SRI Leaders Select index, the German issuer halted the lending programme citing “the need for restrictive collateral parameters and regulator recalls”.
“We do not do any securities lending across our ESG ETFs,” Zeb Saeed, passive product specialist structurer at DWS, told ETF Stream. “There have been a number of historic issues with lending in this space.”
Furthermore, when HSBC Asset Management launched its securities lending programme for its European ETF range in Europe in March, ETF Stream revealed, the UK asset manager decided to exclude its sustainable ETFs.
This is currently industry standard across all ESG ETFs in Europe, driven by investor clear investor sentiment, Saeed added.
In particular, there are three areas which makes securities lending unattractive from a sustainable investing perspective.
The first is around ESG ETFs facilitating short selling. This, according to Saeed, is a big issue for investors as the lending programme enables a stock with strong ESG credentials to be shorted.
When investing in ESG ETFs that securities lend, Paris Jordan, multi-asset analyst at Waverton Investment Management, said investors therefore inadvertently bet against businesses that qualify as a sustainable stock.
“This does not seem to create a virtuous cycle,” Jordan stressed. “Particularly if capital allocation to sustainable businesses is part of the investment philosophy.
“Ultimately, instead, it results in a net effect where the business can be prioritising profit whereas the investor is trying to invest sustainably but it may not have that outcome as they have an offsetting ‘sell’ position they are facilitating.”
The second issue for stock lending with ESG ETFs is voting rights. How ETF issuers engage with the companies in their ESG strategies has become a major talking point for the ecosystem with investors increasingly looking to only invest with issuers that have proper engagement practices.
Highlighting this, a survey of professional investors in Europe conducted by ETF Stream and Amundi earlier this year found 79.8% of respondents said asset manager engagement and voting was either “essential” or “very relevant” when selecting ESG ETFs.
In response to this, Saeed said lending agents have developed recall policies around the time of AGMs to allow ETF issuers to exercise their voting rights.
In a recent report titled Framework for ESG Securities Lending, PASLA and The Risk Management Association said all lenders should look at developing a recall policy based on ESG considerations following a consultation with the market.
“Deciding on an approach necessarily involves accepting a trade-off between the income that can be earned through lending and the investment stewardship responsibility to vote on securities,” the report added.
Finally, another potential issue for ETF providers is around the collateral they receive. While lending out securities that score highly from an ESG perspective, issuers can receive non-ESG securities in return such as controversial weapons or tobacco.
The PASLA and RMA report recommended lenders should apply the same standards to collateral that they are prepared to accept when lending securities in order to align themselves with the way they apply ESG principles to portfolio management.
While limiting collateral is a positive step, Saeed warned this has an impact on the potential returns an ETF can gain from securities lending which leads to questions around why lend in the first place.
“Returns [from lending] can be hampered when limiting collateral,” he stressed. “The trade-off can be very big.”
Overall, the industry appears some way off before investors are comfortable with the knowledge the underlying securities of the ESG ETFs they are pouring assets into are being lent out to third-parties.
As ESG ETFs continue to flourish in Europe, how to square this circle will become an increasingly important issue for the securities lending industry to tackle.
