The Impact of Securities Lending on Index Fund Performance

Abstract

Managers of index funds face competitive pressures to replicate their respective benchmarks as close as possible or risk the loss of investors to competing index funds. As a result, these managers have incentive to take actions to reduce any tracking error. One particular way index funds reduce tracking error is through securities lending activities. The authors examine the impact of securities lending activities on the return performance of index funds and document that reliance on securities lending activity as a means of reducing tracking error has increased significantly over time.