Wednesday, February 20, 2013

Securities Lending by ETFs

By Tim Husson, PhD and Tim Dulaney, PhD

One of the most contentious but least understood aspects of the stock market is short selling.  Short selling refers to selling a stock that you do not own at current market prices, with the hopes that the stock will go down in price.  The stock can be purchased in the market at any time to close out the position and, if the stock has decreased in price, the short-seller will realize a profit.  Obviously, the only way to accomplish this is by borrowing that stock from someone else.

Typically, portfolio managers that have very large stock or mutual fund positions (say, for a pension fund) may loan those securities out to short sellers.  When they do so, they charge an interest rate to the short seller, and thus earn an extra source of revenue.  The rates charged are typically small, but for stocks that are very hard to borrow, that rate can be larger.  These loans are relatively low risk since they are required to be fully collateralized above the mark-to-market value daily (typically at least 102% and perhaps higher depending upon the security).  However, if this collateral is invested in unsafe investments, than as pointed out by Jason Zweig in 2009, investors could unknowingly be financing risky bets by the managing company.

As ETFs have become a larger and larger market force, some ETF issuers have begun lending their shares and thus earning this revenue.  In fact, this is one way in which a passive ETF can outperform its benchmark index net of fees.  While ETFs registered as unit investment trusts (such as SPY) are not allowed to lend its shares in this fashion, others seem to be taking advantage.  As reported by Jason Kephart of InvestmentNews, securities lending proceeds can have a significant impact on ETF returns:
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. 
However, a lawsuit was filed recently (PDF of the complaint here) by two trade unions who argue that iShares, the largest issuer of ETFs in the US, kept too much of that income for itself--up to 40%--instead of passing it along to investors.  Dave Nadig at IndexUniverse argues that while there may be a conflict of interest between ETF issuers lending to short sellers, iShares did nothing out of the ordinary to cause harm to its investors.

We took a look at the ETFs involved in the iShares suit and compared their total returns over the year ending February 15, 2013 to the returns of their underlying index over the same period:

We find that over this period, some funds (IWF, IWO, IWN, IJH and IJR) were indeed able to outperform their respective indexes net of fees.  However, the other funds underperformed, sometimes by even more than their operating expenses.  This suggests that securities lending revenue may not be the most significant cause of tracking error, and may not make up for other sources of deviation between a fund's returns and that of its index.

An interesting sidenote from iShares' IJR prospectus is that "[i]f your Fund shares are loaned out pursuant to a securities lending arrangement, you may lose the ability to treat Fund dividends paid while the shares are held by the borrower as qualified dividend income."  This may be a way in which securities lending could affect ETF investors without investors' prior knowledge.

It's not clear how much of securities lending proceeds should be passed on to investors--perhaps this lawsuit will help speed that discussion.  At the very least, more comprehensive disclosures related to securities lending could help investors (and analysts) better understand what's 'under the hood' of ETF returns.

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