Is It Unfair?

Matt, I suppose iShares would reply, “If we didn’t lend your shares out, you wouldn’t get any extra revenue.”

The fact that the iShares-related securities lending business at BGI was considered worth a couple of billion dollars may come as a surprise to some. But, while iShares perhaps didn’t advertise the fact that it might be earning as much from share lending as it does from the total expense ratio of some funds, the information on how much it earns from both sources is disclosed in the annual accounts of all its ETFs.

To play devil’s advocate, Matt, if you deposit your savings in a bank and receive 0.5% a year interest, and you learn that it’s lent that money out to a credit card borrower at 29.9%, do you expect the bank to pay you even half the difference?

I completely agree with you, though, that any split of securities lending revenues should fairly reflect how risk and reward is divided between the ETF issuer and investor.

Unfortunately the securities lending business, which I find fascinating, is not easy to understand, and even experts can’t give hard and fast answers on this point.

For the last few days I’ve been researching a feature article on the trend towards collateralisation in ETFs and other exchange-traded products, and it’s one of those subjects that gets more complicated, the closer you look at it. Even many hedge fund investors, supposedly the smartest guys on the block, were completely stumped by the Lehman collapse in Europe, when they discovered that their collateral had been “rehypothecated”.

While we like to commend ETFs for being transparent and liquid, we have to face the fact that the last year has thrown open many areas of uncertainty, from counterparty credit issues, to securities lending questions, to – as we reported on the site earlier today – the possible impact of fund closure costs.

What has become increasingly clear is that comparing ETFs purely on the basis of the type of index tracked and the total expense ratio is a very primitive assessment. One needs to look “under the bonnet” and examine all kinds of quite complicated risk factors.

Returning to securities lending and the split of revenues between issuer and investor, I think it’s a good thing that there’s competition in the market, and there are differences in the way ETF issuers operate. As you pointed out, Matt, two of the firms in last year’s survey – XACT and ETFLab – do pass on all securities lending revenues to their fund investors. Ultimately, it’s a free market, and investors can choose with whom they wish to deploy their assets.

There have been some quite significant changes over the year in the way different tracker products have been collateralised, as issuers realise they need to (a) provide better-quality backing and reduce counterparty risks and (b) provide greater transparency to investors. I think that the iShares sale details will already have focussed a lot of people’s attention on securities lending, and issuers will probably have to provide better-quality information there too.

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