Hey, Fund Companies: Share the Wealth; The oft-practiced but rarely disclosed tactic of securities lending has landed BlackRock and State Street in the courts. Here’s what this practice is, and why it matters to you


Hey, Fund Companies: Share the Wealth


The oft-practiced but rarely disclosed tactic of securities lending has landed BlackRock and State Street in the courts. Here’s what this practice is, and why it matters to you.

When funds lend their holdings to short sellers, shareholders take on all of the risk—but they don’t always get to keep all of the profits.

A handful of pension funds and trusts are suing giant asset managers, includingBlackRock (ticker: BLK) and State Street (STT), over the arcane realm of securities lending. The claim: The firms kept too much profit from this corner of fund management for themselves, instead of disbursing more of those profits to exchange-traded-funds’ shareholders and other fund investors.

The lawsuits focus attention on an industrywide practice whereby asset managers lend (usually to institutional short sellers) stock held by its funds in exchange for various fees and cash collateral, on which they collect interest. Securities lending is common enough that it probably contributes to your funds’ returns—so long as the asset manager rewards you with most of the income it collects, instead of keeping gobs of it at the corporate level. The latter is at the heart of the continuing lawsuits, and while it might not be a bad thing for the firms’ stockholders, it behooves you to know who’s getting what. It’s the fund shareholders, after all, taking on the risk of lending the securities.In the most recent suit, the Laborers Local 265 Pension Fund of Cincinnati and the Pipefitters Local No. 572 Pension Fund of Nashville accuse BlackRock of setting up excessive fees to “loot” revenue from iShares ETFs, by allegedly taking at least 40% of lending revenue. BlackRock, which calls the complaint baseless and pledges a vigorous defense, appears to have the upper hand with a motion to dismiss the suit. State Street could face a trial, since a federal judge in Boston rejected requests for summary judgment of a case involving institutional funds.

SECURITIES LENDING ENTAILS risks as well as rewards for both fund shareholders and management. It’s often the tactic that enables a fund company to get an ETF to track an index tightly, helping make up for the drag of management fees. IndexUniverse’s Paul Baiocchi found ETFs that lend securities beat nonlenders by 14 basis points (or 0.14%)—a stark difference between leaders and laggards. While investors benefit from the returns, it’s worth noting that firms benefit, too—they get to claim a strong tracking record for their funds. Many firms take a percentage of profits, while others, like Vanguard Group, put 100% of the profits from securities lending back into the funds. It’s big business: BlackRock earned $397 million from securities-lending fees in 2011. Regulators allow fund managers to lend up to 33% of a fund’s holdings.

There are two main risks in securities lending. One is reinvestment risk—what the fund company does with the cash collateral, which is at least 102% to 105% of the value of the securities lent. That cash goes into a money-market fund, which is safe—until it isn’t. Money-fund regulation is hotly debated, and a Securities and Exchange Commission review last year found more than 300 instances since the 1970s when money funds needed some sort of rescue.

The second risk is borrower default: In the rare instance the borrower goes belly up and can’t return the shares it borrowed, fund shareholders can be on the hook for the loss. Sometimes, the fund company will step in to make investors whole, explains BlackRock’s Dave Lonergan, global co-head of securities lending and financing, who says that iShares investors have “never suffered a loss from securities lending.”

David F. Swensen, who manages Yale University’s endowment, criticized securities lending in his 2000 book, Pioneering Portfolio Management, as “Make a little, make a little, make a little, lose a lot,” which sums up the worst-case scenario.

THE FOCUS ON THE SPLIT of securities-lending revenue is irksome for BlackRock and others in the industry, who point out that iShares investors still get more revenue from lending activities than the competition. In all eight ETFs named in the BlackRock suit, shareholders received more lending revenue in dollar terms than owners of the competing Vanguard funds. The same was true in all but two cases versus State Street. “The iShares securities-lending program has consistently delivered above-average returns,” says BlackRock’s Lonergan. But good luck figuring out whether that’s the result of more lending, more risk, or better methods—or some combination.

Asked if BlackRock’s lending is riskier than programs with lower returns, Lonergan pointed to factors like superior technology, scale, and the combination of lending professionals, portfolio managers, and risk managers under one roof, which “enable us to reduce the operational risks of securities lending in a way that a third party could not.”

BlackRock is one of the most transparent companies: Unlike some competitors, it discloses the proportion of revenue it keeps. There’s no rule for mutual funds or ETFs to disclose what’s on loan or to whom, though things could change. “Disclosure has been steadily increasing over the years,” says Michael Karpik, a senior managing director at State Street Global Advisors, another fairly transparent firm in an opaque business.

With what Markit Group estimates is $1.5 trillion worth of securities currently on loan, it’s surprising things remain so hidden. The European Union agrees: It has recently required ETFs to show where the money is going, so profits can’t be taken in the dark. ETF and fund investors would do well if this were adopted in the U.S.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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