Why The iShares Sale Makes Me Mad

There’s something about the iShares sale that makes me, as an investor, a little angry.

According to Jim and Paul’s report, Barclays turned down bids of $6+ billion for iShares in favor of a $4.3 billion offer from CVC Capital. Why? Because the CVC Capital offer excluded the securities lending business attached to iShares.

I find it absolutely astonishing that nearly one-third of the value in running iShares stems from its securities lending operations. It makes me realize how valuable that securities lending business has become. And that makes me mad.

It makes me mad because, in my opinion, most of that money properly belongs to shareholders of the ETFs.

It’s very hard to get ETF (or other mutual fund) companies to comment on or provide disclosure of how securities lending revenue is split between the fund and the issuer. Paul’s excellent feature in October 2008 is just about the best source of information about this on the Web. Even there, however, we do not have enough details about how much revenue is generated and how much of that money flows back to shareholders.

Barclays should be commended for at least disclosing this info. At iShares, 50% of the proceeds from securities lending is returned to shareholders and 50% is kept by the bank itself. Other banks refuse to comment, and some of the companies offering swaps-based ETFs claim to have no securities lending revenues at all.

In the end, however, even iShares’ 50/50 split is not enough. The shareholders properly own the underlying stocks held by the iShares ETFs; shouldn’t they keep the money from lending those securities out?

It’s a topic for debate in situations where the bank takes on the risk from the collateral. But that’s rare. Mostly, the risk remains with the shareholders. And if they bear the risk, they should reap the rewards.

I understand that there is work involved in lending out securities, just as there is work involved in managing a fund’s long-only investments. Banks needs to be paid for this work. But wouldn’t it make more sense for this payment to be covered by a management fee or, better yet, charged on a per-transaction basis?

This doesn’t apply only to iShares; it applies equally across the industry, except to those companies that deliver 100% of the revenues from securities lending to shareholders.

Shareholders own the securities that are being lent out by the bank. Shouldn’t they reap the rewards?

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