Lawsuit against iShares puts spotlight on securities lending by ETFs

Pension funds contend that BlackRock unit violated its fiduciary duty

By Jason Kephart

Feb 5, 2013 @ 12:55 pm (Updated 3:48 pm) EST

etfs, securities lending, ishares, fiduciary

Exchange-traded funds' securities lending is back in the spotlight because of two pension funds that want a bigger cut of the profits.

The Laborers Local 265 Pension Fund of Cincinnati and the Pipefitters Local No. 572 Pension Fund of Nashville have filed a lawsuit against BlackRock Inc.'s iShares alleging that the company violated its fiduciary duty by taking excessive profits from securities lending.

Funds, including mutual funds and ETFs, can loan their underlying shares to borrowers, primarily short sellers, for a profit of about 40 basis points, according to derivates research firm Markit.

The suit claims that iShares made $397 million in securities lending fees in 2011 and $157 million in second-quarter 2012, and that it kept 40% of those profits for itself. According to BlackRock, it keeps just 35% of net securities lending.

“The complaint is without merit, and we will contest it vigorously,” spokeswoman Melissa Garville wrote in an e-mailed statement. “IShares has a long record of delivering the returns our ETF investors expect, and securities lending is one of the tools we use to help ensure our funds efficiently track the performance of their underlying indices.”

Securities lending plays a big role in the performance of ETFs. In a logical world, ETF investors should expect to get the returns of an index minus the expense ratio.

Earnings from securities lending allow many larger ETFs to outperform their expense ratio, though, according to Mike Rawson, ETF analyst at Morningstar Inc.

“It can have a significant impact,” he said.

The $8.9 billion iShares Core S&P Small-Cap ETF (IJR), for example, had a return of 13.68% for the year that ended Feb. 1, while the index had a return of 13.71%. The ETF has an expense ratio of 16 basis points, but in reality, investors paid just three basis points over the period.

Securities lending has the biggest effect in areas such as small caps or international stocks, where the underlying holdings aren't as readily available as household names like Apple Inc., Mr. Rawson said.

Among the three largest providers — iShares, The Vanguard Group Inc. and State Street Global Advisors — iShares is the least generous with its split of such profits. Vanguard returns 100% of net revenue from securities lending to its funds, and SSgA returns 85%.

The largest ETF, the $127 billion SPDR S&P 500 (SPY), is a notable exception. It is registered as a unit investment trust so isn't allowed to lend out shares.

Although securities lending can be profitable for both shareholders and issuers, it adds another element of risk to owning an ETF.

If a borrower is unable to return the shares, for whatever reason, the ETF would be on the hook for any losses associated with the borrowed stock. Though highly unlikely, such a situation is seen as possible.

“It'd take a black swan-type event,” said Matt Reiner, chief investment officer at Wela Strategies LLC. “We take it into consideration, but we haven't made any decisions based solely on securities lending.”