Transparency is a popular buzzword in the securities industry of late. It's the stock answer to what regulators want about anything that has to do with risk in financial markets.
The latest twist: Analysts and legal experts are questioning whether exchange-traded funds should disclose more about how much they earn from securities lending activities-and what risks are involved.
The debate has been sparked by an announcement made by the world's largest ETF provider, iShares, in January that it would disclose a lot more about its securities lending activities in its quarterly statements.
"For some advisers and investors, knowing the securities practices of an ETF doesn't provide any comfort as to how well the ETF will do, while for others it provides a barometer as to how much expenses will be offset, by earning a return on securities that the fund lends out to borrowers," said Scott Burns, director of ETF research for Morningstar.
There are two kinds of securities lending that take place when it comes to ETFs: lending shares of the ETF overall, and lending of the shares of individual securities held within the fund.
The ETF sponsor can lend out shares of the underlying stocks held by the ETF to earn revenues, which will increase the total return of the fund. The borrowers are typically large brokerage firms, which in turn may lend them out to their own fund manager clients, often hedge funds.
"There is a great disparity in how much information is offered by exchange-traded funds about their securities lending practices," said Dave Nadig, director of research for IndexUniverse.com, a San Francisco-based publication and research firm specializing in exchange-traded funds. "Investors and advisers should know more about the revenues earned, the split with securities lending managers and any risk management practices."
Securities lending has attracted greater scrutiny since the bankruptcy of Lehman Brothers in 2008 led to heightened concerns about counterparty risk.
In that case, fund managers lent securities to Lehman-and couldn't get them back. The lesson: One of the key risks with securities lending is that a borrower of shares could default on its commitment to return borrowed securities and the value of any collateral might fail to cover the cost of repurchasing the assets lent out.
ETFs do disclose in their prospectuses whether or not they are engaging in securities lending activities and how they mitigate the risk involved if their counterparty should default in their prospectuses.
However, it is far more difficult to find information on how much net revenue they bring in from the lending. Also undisclosed is how interest earned from securities lending is divided between the fund itself-to benefit investors-and the manager of the securities lending program. The more money the ETF pays to the manager of its securities lending program, the less money is left for the investors to offset administrative expenses of the fund.
Listing the split, or how much revenue is kept by the ETF provider versus how much goes to fund investors, would illustrate to investors how much of the fund's fee potentially would be offset by share-lending activities. For instance, if the fund got to keep all of the share-lending revenue, investor returns would increase far more.
"Our securities lending practices are fully disclosed in our funds' annual reports," said Linda Wolohan, a spokeswoman for Vanguard.
Among those disclosures are the fact that Vanguard holds collateral from its counterparty that is worth 102% to 105% of the securities lent out and that the borrowed securities are valued on a daily basis. The collateral is also invested in a diversified portfolio of money-market instruments.
However, is the information actually used by investors or advisers to decide which ETFs they should buy or recommend? IndexUniverse's Nadig thinks so. "They will be looking at how much the revenues earned offset the expenses to the fund," he said. "Knowing the fee split with the lending manager might push some investors to choose a different ETF product," said Morningstar's Burns.
Others aren't so certain. "The revenues earned from securities lending don't affect the actual net asset value of the ETF's shares and the risk of financial loss due to securities lending being minimal if any," said Gary Gastineau, president of ETF Consultants, a Summit, N.J. firm specializing in ETF management. "The lending agent usually guarantees that there will not be a loss from the lending program."
iShares, owned by BlackRock, did not return calls seeking comment last week. However, in January it said that the risk and quantitative analysis (ROA) group of its parent BlackRock is responsible for selecting creditworthy borrowers and to determine collateral parameters-how much to ask for a security and to decide how it should be made up from stocks, bonds and other instruments. The value of the collateral-which can be in cash or securities-ranges between 102.5% and 112% of the value of the loan and is marked-to-market daily.
BlackRock's risk management procedures aren't that unusual among ETF providers. What is unusual is the low percentage of fees generated from securities lending that are put back into the ETF. In January, iShares said that 60% of its revenues from securities lending was returned to the fund and 40% was returned to BlackRock. Those figures are still better than the previous industry estimates of a 50-50 split when iShares was owned by Barclays.
But the split falls short of what some other ETF providers do, say ETF experts.
A study conducted of the securities lending practices of the ETF industry by IndexUniverse.com last year showed that Vanguard returns 100% of the revenue if makes in securities lending to investors after taking expenses. WisdomTree returns 70%, while State Street Global Advisors returns 85%. As a result, iShares' disclosure may be far more aimed at appeasing investors who were unhappy about the fee split.
Should the revenue split matter?
John McGuire, a partner in the law firm of Morgan, Lewis & Bockius in Washington, doesn't think so. "There will always be a variation in the revenue split, but that doesn't mean the manager of the securities lending program won't earn its keep," McGuire said. "In fact, it might actually generate more in revenues for the fund than other managers which keep less of the split."
McGuire said that when it comes to securities lending, investors should ensure that the collateral is invested safely. And that information is disclosed in an ETF's annual report.