In certain pockets of the industry, ETFs are consistently beating the return on the indexes they're meant to track. Theoretically, an ETF should lag its index by roughly the amount of its fee to investors. But that doesn't account for revenue from securities lending. ETFs can lend out as much as 33 percent of their equity holdings to short sellers in return for a small fee. ETFs can then use that revenue to offset the expense ratio. In some cases, an ETF has securities in its portfolio that are in such high demand from short sellers that the lending fees add up to more than the fund's expense ratio—so the ETF not only makes up its fees but also pushes returns above those of the index.
The most prominent examples of this phenomenon are in ETFs that track small-cap indexes. State Street Corp., BlackRock Inc.'s iShares, and Vanguard Group Inc. all have small-cap ETFs—with more than $30 billion in collective assets—whose extra revenue from securities lending leads to returns that top those of the indexes they track.
Small-cap stocks have traditionally been harder securities to borrow than large-caps because fewer shares are floating around. Plus, there's high demand to short smaller stocks because the payoff can be greater—they're more volatile and can fall farther and faster. This is why much of the demand to borrow these securities comes from hedge funds, according to multiple ETF issuers.
So the small investor actually makes money off the hedge funds. That's fun. But small-cap ETFs are down more than 17 percent in the past year, so why care about being paid a few extra basis points to own such lousy performers? The reason may be that many of the ETFs are actually beating their index over the long term. The largest of the bunch, IWM, has been posting benchmark-beating performance for a while now, as seen in the five-year return chart below. Not only did investors get free exposure to the Russell 2000 Index’s 27.9 percent return; they got paid an extra 0.25 percent on top.
While small-cap ETFs are the largest and most consistent category where this happens, some other types of ETFs are returning more than their indexes. One example is the SPDR S&P Biotech ETF (XBI), which has beaten its index by 0.37 percent over the past year. No shocker—smaller biotech names are in high demand to short.
All this points to an underrated metric in the ETF world called tracking difference. It's the gap between the ETF’s total return and the index’s total return, and it can be helpful in determining the true cost—or lack thereof—of an ETF.