Lawsuit against iShares puts spotlight on securities lending by ETFs

Exchange-traded funds' securities lending is back in the spotlight because of two pension funds that want a bigger cut of the profits.

Exchange-traded funds’ securities lending is back in the spotlight because of two pension funds that want a bigger cut of the profits.

The Laborers Local 265 Pension Fund of Cincinnati and the Pipefitters Local No. 572 Pension Fund of Nashville, Tenn., have filed a lawsuit against BlackRock Inc.’s iShares unit alleging that the company violated its fiduciary duty by taking excessive profits from securities lending.

Funds, including mutual funds and ETFs, can loan their underlying shares to borrowers, primarily short-sellers, for a profit of about 40 basis points, according to research firm Markit Group Ltd.

The suit claims that iShares made $397 million in securities lending fees in 2011 and $157 million in the second quarter of 2012, and that it kept 40% of those profits for itself. According to BlackRock, it keeps just 35% of net securities lending.

“ONE OF THE TOOLS’

“The complaint is without merit, and we will contest it vigorously,” spokeswoman Melissa Garville wrote in an e-mail. “iShares has a long record of delivering the returns our ETF investors expect, and securities lending is one of the tools we use to help ensure our funds efficiently track the performance of their underlying indices.”

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, an ETF analyst at Morningstar Inc.

“It can have a significant impact,” he said.

The $8.9 billion iShares Core S&P Small-Cap ETF (IJR), for example, had a return of 13.68% for the 12-month period ended Feb. 1, while the index had a return of 13.71%. The ETF has an expense ratio of 16 basis points, but in reality, investors paid just 3 basis points over the period.

Among the three largest providers — iShares, The Vanguard Group Inc. and State Street Global Advisors — iShares is the least generous with its split of such profits. Vanguard returns 100% of net revenue from securities lending to its funds, and SSgA returns 85%.

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