Hot market, ETF popularity hurting securities lending

Pension funds, exchange-traded funds and securities lending are sharing the spotlight recently for all the wrong reasons.

Two Tennessee-based pension funds are suing iShares and units of parent company BlackRock Inc., as well as the named directors of the iShares Trust, concerning the securities lending arrangement between iShares ETFs and its affiliated lending agent.

The suit, filed in the U.S. District Court for the Middle District of Tennessee, claims the trust directors breached their fiduciary duty with regard to compensation and payment to units of New York-based BlackRock. Through a spokeswoman, iShares said “the complaint is without merit” and the firm intends to contest it “vigorously.”

The securities lending arrangements between any mutual fund — ETF or otherwise — and affiliated or third-party lending agents can often be inscrutable and effectiveness is difficult to measure. When it comes to pension funds as holders of ETFs, however, the effectiveness of their own securities lending program depends directly on the extent of their ETF use.

For ETFs, the securities lending market has been somewhat undone by both the consistent bull market and the popularity of ETFs themselves, nearly doubling in assets to $1.43 trillion since the end of 2009, according to XTF Inc., New York.

Larry Swartz, chief investment officer of the Fairfax County (Va.) Retirement System, said the decline in lending income, particularly on a broad-based emerging market ETF, has him reconsidering the switch from a traditional fund. 

 “We transitioned from an emerging market index fund to an ETF beginning in 2006 to take advantage of the securities lending demand for the ETF,” he said. “Now that the securities lending advantage has evaporated, we are reviewing how best to obtain the desired exposure moving forward.”

The average “return to lendable” for ETFs in a lending program has rested slighted above 10 basis points (annualized) for the better part of a year after eclipsing 20 basis points in 2010 and 2011, according to Markit Securities Finance, London, which aggregates securities loan data. As a contrast, the fee to borrow ETFs, in aggregate, has recently ranged from 50 basis points to 60 basis points, up from 30 basis points to 40 basis points just two years ago.

Driving these trends is the rush of institutional money into ETFs and subsequently into lending programs, coupled with decreased demand for borrowing ETFs for shorting or covering trade fails. In the last three years, ETF assets available to borrowers have grown to almost $60 billion from $35 billion in 2010 while ETF assets on loan have dropped to around $9 billion from peaks near $14 billion.

Utilization, a measure of demand, has fallen to 15% from nearly 35% over the same time period, according to Markit.

“The demand to borrow just has not kept pace,” said Simon Colvin, a London-based vice president for Markit.

According to David Lonergan, managing director and head of securities lending strategy for BlackRock, demand to borrow specific ETFs or indexes is based largely on market sentiment and what sectors are in and out of favor.

“The majority of demand for shorting is around specific emerging market ETFs,” said Paul Lynch, chief operating officer at eSecLending in Boston. “But the cost to borrow is driven by both the supply and demand as well as the cost to create new shares of an ETF.”

ETF creation (or redemption) fees can run to more than $40,000 and consideration for a prime broker to create new shares of an ETF can, in turn, be influenced by the cost of acquiring or borrowing shares of the underlying securities.

For that same reason, an institutional investor might be better served to own an index of securities directly in which some of the individual securities are highly valuable from a securities lending perspective whereas the ETF as a whole is less valuable.

The sharing of this revenue by the lending agent is at the core of the suit against iShares.

Dave Nadig, head of research for IndexUniverse, San Francisco, sees the suit as grasping at the fee structure without looking at the result, which allowed iShares to overcome its expense ratio and even more effectively track some indexes compared to other ETFs with both lower expense ratios and higher proportional securities lending revenue to the fund.

As to what may reinvigorate demand for securities lending in broad-based equity index ETFs, look for a rise in correlations and an increase in volatility to bring the bears back. n