October 19, 2011 / 2:36 PM / 8 years ago

Analysis: ETFs keep investors in the dark about lending gains

(Reuters) - U.S. exchange-traded funds may claim to be transparent. But critics say some investors are not being fully credited with gains from a side business ETF providers engage in and neither are they being informed of the practice.

U.S. ETF funds are lending out the shares, and taking bets with the collateral they get on the loans — which should be good for investors as it can help to spice returns.

The only problem is that fund investors often do not earn 100 percent of the gains that the funds eke out and could end up on the hook for any losses that result from investing the collateral, ETF experts say.

The largest provider of ETFs, BlackRock’s iShares — keeps 35 percent of the money it makes investing the collateral it gets in return for the securities it lends.

“Securities lending is compensation for bearing a type of risk and if you aren’t’ getting fully compensated for bearing that risk, it may not be a great deal,” said Samuel Lee, an ETF analyst at Morningstar Inc.

The critics say it is the kind of issue that lawmakers should study as they scrutinize the ETF business - there is a U.S. Senate subcommittee hearing about the sector on Wednesday.

Securities lending is commonplace in the mutual fund industry and as ETFs have grown in size, more are adopting the practice. Several large ETF providers engage in the practice, including The Vanguard Group, iShares and State Street Global Advisors. PowerShares began lending securities earlier this year and Pacific Investment Management Co. has filed to do so.

In short, the fund lends out securities to outside investors in exchange for collateral and a fee.

In a typical transaction, the borrower posts 102 percent to 105 percent of the shares’ value in the form of cash or cash equivalents. The ETF provider then invests the extra 2 to 5 percent.

Data Explorers, which tracks securities financing data, said it has no way to track how much of the underlying securities ETF providers have on loan.

Since the collateral more than covers the value of the shares being loaned, there is little risk to the lender if the borrower defaults on the loan, said Dave Nadig, director of research at IndexUniverse, an ETF research company.

What’s more, since ETFs, which are largely index based, produce slim profit margins for the providers, Lee and other analysts say there is ample incentive for ETF firms to be more aggressive with how they invest.

The Securities and Exchange Commission, which regulates ETFs, is looking at ways to increase transparency about securities lending practices to brokers and investors as part of the Dodd-Frank financial reform law, spokesman John Nester told Reuters in an e-mailed statement.


Few investors know how much risk they are taking on through the investments made with excess collateral from securities lending. More than that, investors are in the dark about how they’re rewarded for that risk, Nadig said.

ETF providers also are not required to publicly disclose what share of revenue from securities lending investments they put back into their funds.

The revenue split varies widely.

Vanguard Group puts 100 percent of securities lending revenue back into the fund, minus associated expenses.

State Street Global Advisers returns 85 percent of its revenues into the fund. Jim Ross, global head of ETFs at State Street, said that 15 percent doesn’t always cover the costs of the program.

Until last year, iShares returned just 50 percent of securities lending revenue to the funds. Last October, iShares increased that to 65 percent, but analysts say that investors should get more since they take on all the risk.

The split in lending gains is not the whole story, said David Lonergan, managing director at BlackRock. The firm believes securities lending “produces returns... in excess of the risks. Some agent lenders are able to generate more revenue,” he said.

ETF providers only have to disclose revenues from securities lending if it exceeds 5 percent of total investment income, information that is available in fund’s annual and semi-annual filings.

As it stands, providers often bundle revenue earned from securities lending with other revenue, so it can be hard for investors to figure out how much money was made — or lost — through securities lending alone, said Matt Hougan, president of ETF analytics at IndexUniverse.

Even when reported separately, comparisons of funds to gauge performance of the collateral investments is nearly impossible because there’s no uniform period for reporting.


Then there’s the risk of losses on the bets providers make with excess collateral from securities lending. Many ETF providers, including Vanguard, iShares and State Street Global Investors, told Reuters that they invest the lending collateral in money market funds. But there’s no requirement to invest the money conservatively.

“(Providers) could invest in riskier things like corporate or longer maturity bonds so you can earn bigger interest rates,” said Morningstar’s Lee.

If $100,000 in excess collateral is invested aggressively and loses 10 percent of its value, the fund — and its investors — might end up eating the $10,000 loss.

It would be up to the fund boards to decide whether the company bears the loss, the fund takes the hit, or some combination, said Barry Barbash, a partner at Wilkie Farr & Gallagher LLP, and a former director of the Division of Investment Management at the SEC

Still, some fund lawyers, like Barbash, say greater transparency about securities lending probably wouldn’t garner much attention from investors given it is so esoteric.

“I don’t think investors are really going to understand securities lending,” Barbash said. “That is why it’s up to the fund boards to understand these nuances.”

(Corrects 10th paragraph in Oct. 18 story to show Data Explorers does not track data on ETF securities lending)

Reporting by Jessica Toonkel, editing by Jennifer Merritt and Martin Howell

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