Securities lending: Boon or bane?

ETFs that lend portfolio securities can generate additional income, but disclosure on those activities isn't forthright

Apr 20, 2014 @ 12:01 am

By Ed Mccarthy

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The practice among exchange-traded funds of lending portfolio securities to other institutional investors has drawn attention lately.

Some observers view it as an established, low-risk way for funds to generate additional income for shareholders. Others stress the practice's potential risks and argue that funds' reports of aggregated lending data give shareholders little genuine information.

Either way, lending is popular among ETFs.

Dave Nadig, chief investment officer with fund analytics firm ETF.com, said that 672 of the 1,575 exchange-traded products his firm tracks have active securities-lending programs.

Not all funds can lend, he noted, because their assets aren't suitable.

HOW IT WORKS

The mechanics are straightforward. Potential borrowers can include broker-dealers, hedge funds, proprietary trading desks and other institutional investors who need the shares for market making, short sales or other purposes.

Lending agents typically facilitate transactions. These agents can be independent third parties or owned by an institutional investor or custodian.

An ETF temporarily transfers securities to a borrower who provides collateral to cover the loaned securities' value. If the loaned securities earn interest or dividends, the ETF receives those payments.

Most loans are callable, while others are for a term.

Cash is the most common form of collateral, though some loans involve other securities. The collateral amount exceeds the loaned securities' value, usually by 2% to 5%, to provide a cushion to the lender.

Peter Bassler, managing director with eSecLending, an independent lending agent, provides an example of a transaction in which The Goldman Sachs Group Inc. wants to borrow International Business Machines Corp. shares.

"Let's say we lend out $100 of IBM; Goldman Sachs gives us $102 of cash," he said.

"Then, every day, depending on the value of IBM, we will either return collateral to Goldman or ask for more collateral. So the transaction is marked to market daily," Mr. Bassler said.

Lending generates substantial revenue for some ETFs. They can earn fees on the loans, depending on the scarcity of the security.

The funds also invest the cash collateral, or loan out the securities they receive.

For example, according to the March 31, 2013, annual report for the iShares Russell 2000 ETF (IWM), the latest available, securities lending accounted for $45.6 million of the fund's $346.2 million total investment income for the preceding year.

Lending income can offset a fund's management fee, allowing the fund to track its benchmark index more closely.

The IWM's management fee is 20 basis points, for instance. Its annualized securities-lending return for the six-month period ended Sept. 30 was also 20 basis points.

The percentage offset varies among funds: Over the same period, the iShares U.S. Preferred Stock Fund (PFF) offset just 18% of its management fee.

Funds typically split their lending income with the lending agent.

The income percentage refunded to shareholders ranges from 65%-70% to 100%, Mr. Nadig said.

Among SPDR ETFs, for instance, 85% of securities-lending fees go back to the fund, with the remaining 15% to the lending agent, according to Timothy Coyne, global head of ETF Capital Markets Group at State Street Global Advisors.

Of course, there is no such thing as a free lunch.

The primary risk of lending securities is the borrower's defaulting and failing to return the borrowed securities. Funds and lending agents think this risk can be mitigated by the continued screening of borrowers and internal controls to prevent an excessive loan exposure in any fund or to a single borrower.

Some lending agents also indemnify funds against borrowers' defaults. If a borrower defaults, the agent will cover any financial shortfall incurred in replacing the securities.

Mr. Nadig provides a hypothetical example.

An ETF loans out shares of Microsoft Corp. (MSFT) and receives collateral worth 104% of the shares' value. The borrower goes bankrupt the next day.

The ETF can't recall its shares, so it must sell the collateral and use the proceeds to repurchase MSFT.

In order for the fund to lose money, MSFT's price must move up more than 4% between the counterparty's bankruptcy and the repurchase, Mr. Nadig said.

VERY FEW DEFAULTS

Defaults haven't been a problem for ETFs.

Just three borrowers with active loans have defaulted in over 30 years, according to BlackRock Inc.'s background materials on its funds' securities-lending practices.

In each case, BlackRock was able to repurchase the loaned securities without any losses to clients.

"The reality is, it just doesn't happen often, and the actual losses would be extremely small," Mr. Nadig wrote in an e-mail. "Even in a black-swan-type event like Lehman [Brothers Holdings Inc.] — where there were securities-lending losses — it's only in the insufficiently collateralized programs (which in regulated mutual funds don't happen, as there are rules from the Securities and Exchange Commission about collateral in place) that you had any real balance sheet losses by the lenders."

A second potential risk results from how the fund invests the cash collateral it receives. Parking it in a money market fund — as BlackRock, State Street, The Vanguard Group Inc. and others do — is the conservative option.

Neither of these risks concerns the handful of investment advisers contacted for this article. They know about funds' loans and are comfortable with the practice. They focus instead on factors such as benchmark tracking, expenses and liquidity.

LIMITED INFORMATION

Getting details on securities-lending activities can take some digging.

Funds provide summary results in their annual reports and statements of additional information. Some sponsors also are aggregating that information in separate publications.

ETF.com tracks funds' efficiency ratios and the percentage of lending income coming back to the fund.

That is about it for analytics. Financial advisers aren't going to find real-time, detailed reports on an ETF's specific lending activities.

But would that level of granularity help advisers make better-informed decisions? The information's value would depend on its presentation and accompanying analysis.

In any case, details aren't available, though some observers wish they were.

"Personally, I'd love to see more disclosure of securities-lending activity," Mr. Nadig said.

"While the risks are really de minimis, it is, after all, your money," he said. "Shouldn't you get to see how it's being used?"

Ed McCarthy is a certified financial planner and freelance financial writer in Pascoag, R.I.

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