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Faulty Math In iShares Sec-Lending Suit

Dave Nadig

A lawsuit shines a light in a dark corner, but what exactly is that light going to find? Probably not much.

As reported here (and everywhere else), BlackRock, the issuer of the popular iShares brand of ETFs, has been sued by a group of Tennessee pension plans for the structure and fees associated with the ETF securities-lending programs.

My initial reaction on hearing this news, to be honest, was to yawn. Yes, BlackRock splits its securities-lending revenue at one of the lowest rates in the business, returning just 65 percent of topline revenue to the funds whose securities it lends out. But every time this story comes up, there seem to be apples-and-oranges comparisons.

First, it’s worth actually reading the complaint , but full warning, it’s a long one.

The suit goes into exhaustive detail about the securities-lending business, the relationship of various BlackRock subsidiaries and how the whole thing works. It also comes with a very clear moral angle as well:It flat-out declares that securities lending, regardless of who profits, is a direct conflict of interest with long-term investment management.

Here’s an example:“Securities lending by any mutual fund involves an inherent conflict of interest because it facilitates short sellers who are trying to drive down the price of the very shares that funds are lending.”

While there’s some truth to that—short-selling is indeed the main driver of securities-lending demand–since virtually all large pools of assets can loan securities, a fund that chooses not to loan is missing the only opportunity it has to make lemonade out of the short-sellers’ lemons.

But that’s neither here nor there. The main point of the suit is that the pension funds really think BlackRock is just charging too much. BlackRock takes a flat 35 percent of all top-line revenue from securities lending. Vanguard and State Street, by comparison, take nothing from securities-lending profits .

The real question is this:Does the profit incentive at BlackRock work for or against investors? Obviously, if BlackRock started taking crazy risks with its securities-lending program in order to boost the company’s bottom line, that would be bad.

But we don’t actually see any evidence of that.


Conversely, since Vanguard and State Street don’t have any direct profit motive to run their securities-lending programs well (which are generally run through external third parties), well, that’s bad too. Of course, it shows up in performance, which every manager wants.

A lack of comprehensive disclosure on exactly how much money is really being made, when and where, makes sussing out these differences problematic. You can dig deep into a fund’s annual report to get a sense of how well its securities-lending program is run, but you better come armed with an Excel spreadsheet.

Our advice? Investors should probably focus on their actual bottom line. Let’s look at just one asset class:small-cap value. It’s not a random choice:One of the funds that the lawsuit calls out as a signal example is the iShares Russell 2000 Value ETF (IWN).

There’s no doubt that iShares did well lending out IWN. In fact, thanks to SEC filings, we know that BlackRock made exactly $3,258,389 in fees just from lending securities for that fund in the year ending March 31, 2012. Based on the 65/35 split, that means the fund made $6,051,294.

In that same year, the fund paid a total of $10,021,426 in investment advisory fees. In other words, the securities-lending program earned back 60 percent of the fee the fund would otherwise have paid.

You can see this in another statistic that’s a lot easier to find. In our ETF Analytics system, we calculate 12-month rolling tracking difference. Over any 12-month period, a perfect index fund would trail its index by exactly the amount of its expense ratio. In the case of IWN, that would mean the fund’s median 12-month holding period return should be 37 bps behind the Russell 2000 Value Index. Instead, it’s 12 bps behind. The difference?

That 60 percent offset from securities lending.

To see an apples-to-apples comparison, we can turn to Vanguard Russell 2000 Value ETF (VTWV), which tracks the same index as iShares’ IWN. In its year ending Aug. 31, 2012, it paid $208,000 in expenses, and earned $87,000 in securities-lending revenue—or 41 percent of its fee.

Again, you can just look at tracking difference to see this in your bottom line. Over a median 12-month holding period, VTWV has trailed its index not by its 32 bps expense ratio, but by 15 bps. It’s still better than nothing, but is it better than BlackRock?

From an investor’s perspective, you’ve actually been—in this one case, to be sure—better off in iShares’ product than the cheaper Vanguard fund, entirely because of BlackRock’s extremely effective securities lending.

Yes, BlackRock charges a higher management fee; yes, it arrogates 35 percent of the securities-lending profit. But as an investor, you ended up closer to the index, on average, in the BlackRock product because the securities-lending program generated so much more revenue.

Now obviously, not every fund is like this. I’m sure that with enough digging we could find an inverse example. And for sure, I have no doubt BlackRock is making a pretty penny running its securities-lending program.

But the Tennessee Laborers Local 265 singled out IWN, not me, and the union is complaining that it thinks a Vanguard-style program would have been better for them, and that BlackRock’s incentives here are to the detriment of performance.

I’m wondering if they’ve done the actual math.

At the time this article was written, the author held no positions in the securities mentioned. Contact Dave Nadig at dnadig@indexuniverse.com .


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