The growth of equity index (passive) investing has been a market-changing phenomenon. The prospect of broad market exposure at a cost-effective price has seen investors consistently increasing their allocation to passives over the past decade. The end of 2023 marked a turning point, where passive investing overtook active investing in terms of assets under management (Morningstar, 31 December 2023).^[1] As the market for passives has grown and matured, the index approach has evolved along with it.

The big question facing investors in passives now is not just where to allocate, but also how to make the most efficient use of their ever-increasing passive inventory.

The evolution in equity index approaches

From the initial use of traditional market cap weighted equity index strategies, institutional allocations to index equities have adapted to include systematic index approaches that allocate to holdings based on a series of factors such as value, momentum, low-volatility and quality. In recent years the inclusion of environmental, social and governance (ESG) factors within index construction has become more popular. This includes systematically tilting allocations towards ESG leaders and/or leaders in climate change emissions reduction.

But what is the potential next evolution in this journey, that can make an index allocation work harder for investors?

The answer might lie in making more efficient use of the stock lending value chain.

So what is stock lending?

A passive index portfolio can generate excess returns by temporarily loaning out a stock, typically to a financial institution (eg. an investment bank).

These assets are typically borrowed by the investment bank to lend out to third parties to facilitate further trading activities, such as short selling, or hedging. The fee earnt by the passive index portfolio for stock lending tends to be very low. On a typical equity portfolio, the fee can be anything from around 1 to 2 basis points (bps) (0.01% or 0.02%) per annum to perhaps 5 bps, although it varies depending on the region and availability of the stock inventory (ie. small cap stocks can receive a higher fee).

The stock lending chain

 Investors who allocate to passives will be familiar and comfortable with the use of basic stock lending (Exhibit 1). However, it is the next step, the subsequent lending chain, where the process gets interesting.

Source: Janus Henderson Investors. Used here as an example to illustrate how payment can be allocated across a stock lending chain, as a proportion of an underlying 1% hedge fund trade opportunity.

Once investment banks have borrowed a stock that they will lend those stocks on to investors that could, for example, sell them to create a short position. The investment bank, effectively acting as a ‘middle man’, can charge around 30 to 50 basis points per annum for this (0.3% to 0.5%), pocketing the difference between that fee and the small fee paid to borrow the stock in the first place.

The value chain opportunity

Stock lending can be an inefficient space, dominated by investment banks. The question is whether a passive portfolio could extend into that inefficient domain so that investors take more of that value chain for themselves.

Can investors potentially improve their outcomes by working their passive index assets harder through innovative enhancement strategies?

Rather than letting a bank and hedge fund profit from the additional revenues generated through the lending stock, investors can extend the value chain by underweighting certain stocks held in a passive inventory and substituting with alternative positions to generate additional returns.

The argument is that, by disintermediating investment banks and hedge funds, it is possible to monetise that whole revenue stream – the combination of investment bank stock lending fees PLUS returns from alternative trading strategies on the stock positions – within an enhanced index portfolio.

This applies to stock that investors already own in their passive portfolio, meaning that it can be implemented without having to borrow stock (at a cost) and selling it short, although it does mean forgoing the potential stock lending revenue on any underweight positions.

What are the key advantages for investors?

1) Delivering enhanced returns from a passive core

Investors can potentially tap additional return from the existing stock lending value chain without adding material risk to their portfolios.

2) Diversification from other equity approaches

It offers a style agnostic approach with returns that have historically been uncorrelated with traditional long-only investment techniques, potentially offering diversification benefits.

3) Increasing access to alternative investment ideas

Investors have been craving alternative sources of growth. This investment approach can provide an efficient and liquid route to accessing alternative investment ideas.

What’s the secret sauce?

Passive allocations have been a popular choice for those investors keen to reduce the cost of their investments, and benefiting from the visibility that comes with allocating to large benchmark indices. Ultimately it comes back to whether or not investors want to leave potential performance on the table. A curated enhanced index approach, built using experience and expertise, facilitated via dedicated infrastructure and systems designed to help manage opportunities, can potentially help to make a passive allocation work harder for investors, within an existing risk and price framework.

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[1] Source: Morningstar Direct Asset Flows, at 31 December 2023. Active assets vs passive assets. https://www.morningstar.com/funds/recovery-us-fund-flows-was-weak-2023