Passive funds gain upper hand
05 September 2017
The collateral shortage has made the tough passive fund even tougher. IHS Markit analyst Simon Colvin reports
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The term ‘disruption’ gets thrown around a lot today, however, there is no denying that the asset management industry has felt more than its fair share of disruptive innovation in the years since the financial crisis. Much like more parochial niches such as retail, food distribution or even mattresses, the twin siren songs of improved efficiency and lower cost promised by upstart passive funds have proved too much of a temptation for investors to resist. Spurred on by the desire to cut costs, and the growing realisation that the extra costs levied by incumbent fund managers don’t guarantee outperformance, what had been a trickle into passive funds has turned into a deluge.
Money riding this wave of disruption is showing no signs of drying up anytime soon, as it has only taken to mid-August for the global exchange-traded fund (ETF) industry to beat its previous full year inflow record.
The $4.3 billion now managed by ETFs globally, and the even larger sum allocated to passive fund trackers, is now starting to make waves in the securities lending space. In fact, these funds are now responsible for nearly two thirds of all global securities lendable inventory according to the funds contributing to the IHS Markit Securities Finance database. This share has, not surprisingly, grown over the years as passive funds were responsible for less than half of the global inventory before the crisis in 2008.
Astonishingly, these ‘boring’ funds are actually able to generate more revenues in the securities lending market than their actively managed peers. Over the past three years, passive funds have earned an average total return of 5.1 basis points (bps), which is 14 percent more than the 4.5 bps earned by actively managed funds over the same period.
One reason behind this outperformance is due to the fact that passive funds are, by and large, more pragmatic when it comes to the type of assets that they are willing to receive as collateral for securities lending transactions.
Our data indicates that 36 percent of active funds will only accept high-quality G7 bonds as non-cash collateral. Passively managed funds on the other hand are much less picky when it comes to collateral, as only 20 percent of these funds by assets under management will only lend securities against the highest quality collateral. This means that fully 80 percent of all passive inventories are available to borrowers with some sort of lower quality collateral, such as G10 bonds or equities.
These numbers may not seem drastic at first glance, but we all know that the industry’s chronic oversupply means this is very much a buyer’s market when it comes to selecting potential counterparties. The advent of derivatives clearing regulation has further fuelled this trend as borrowers now have to ration collateral to fuel other activities within their organisations. Ironically, these collateral shortages have created opportunities in the market, but mainly for lenders that are willing to lend out high-quality liquid assets to holders of relatively lower quality collateral.
European sovereign bonds, which is one such asset class, highlights this trend perfectly. The funds that are willing to lend out the asset class against assets other than G7 government bonds have been able to generate an average total return of 4.8 bps over the past three years. Pickier G7-only lenders haven’t been able to achieve even half these returns over the same period of time, mostly due to the fact that the utilisation rates achieved by their inventory has been half of that seen by their more pragmatic peers.
For now, passive investment funds have been better able to capitalise on the collateral shortage as their willingness to be more pragmatic when it comes to collateral makes them better potential counterparts. Being able to use ancillary activities, such as securities lending, to drive down the cost of their already cheap products is part of the disruptive appeal of passive funds and the collateral shortage had made a tough competitor even tougher.
Money riding this wave of disruption is showing no signs of drying up anytime soon, as it has only taken to mid-August for the global exchange-traded fund (ETF) industry to beat its previous full year inflow record.
The $4.3 billion now managed by ETFs globally, and the even larger sum allocated to passive fund trackers, is now starting to make waves in the securities lending space. In fact, these funds are now responsible for nearly two thirds of all global securities lendable inventory according to the funds contributing to the IHS Markit Securities Finance database. This share has, not surprisingly, grown over the years as passive funds were responsible for less than half of the global inventory before the crisis in 2008.
Astonishingly, these ‘boring’ funds are actually able to generate more revenues in the securities lending market than their actively managed peers. Over the past three years, passive funds have earned an average total return of 5.1 basis points (bps), which is 14 percent more than the 4.5 bps earned by actively managed funds over the same period.
One reason behind this outperformance is due to the fact that passive funds are, by and large, more pragmatic when it comes to the type of assets that they are willing to receive as collateral for securities lending transactions.
Our data indicates that 36 percent of active funds will only accept high-quality G7 bonds as non-cash collateral. Passively managed funds on the other hand are much less picky when it comes to collateral, as only 20 percent of these funds by assets under management will only lend securities against the highest quality collateral. This means that fully 80 percent of all passive inventories are available to borrowers with some sort of lower quality collateral, such as G10 bonds or equities.
These numbers may not seem drastic at first glance, but we all know that the industry’s chronic oversupply means this is very much a buyer’s market when it comes to selecting potential counterparties. The advent of derivatives clearing regulation has further fuelled this trend as borrowers now have to ration collateral to fuel other activities within their organisations. Ironically, these collateral shortages have created opportunities in the market, but mainly for lenders that are willing to lend out high-quality liquid assets to holders of relatively lower quality collateral.
European sovereign bonds, which is one such asset class, highlights this trend perfectly. The funds that are willing to lend out the asset class against assets other than G7 government bonds have been able to generate an average total return of 4.8 bps over the past three years. Pickier G7-only lenders haven’t been able to achieve even half these returns over the same period of time, mostly due to the fact that the utilisation rates achieved by their inventory has been half of that seen by their more pragmatic peers.
For now, passive investment funds have been better able to capitalise on the collateral shortage as their willingness to be more pragmatic when it comes to collateral makes them better potential counterparts. Being able to use ancillary activities, such as securities lending, to drive down the cost of their already cheap products is part of the disruptive appeal of passive funds and the collateral shortage had made a tough competitor even tougher.
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