Only a few weeks after committing to full transparency in its swap-based ETFs, iShares is ingratiating itself to investors again. This time, it relates to the securities lending programme within its physical replication ETFs. From November 1, all European in-kind iShares ETFs will split the net income generated from securities lending within these funds 60/40--in favour of fund shareholders. Previously, only German-domiciled iShares funds enjoyed a 60/40 split, while the vast majority of iShares ETFs--domiciled in Ireland-- received only 50% of the income generated from securities lending.
This initiative, which is aimed at bringing consistency across the product range, is a positive development for investors. It should theoretically help further enhance the return of iShares ETFs which engage in securities lending, and thereby help to reduce tracking error.
Last year, nearly half of all Dublin-domiciled iShares ETFs earned additional income as a result of securities lending. These lending activities helped to partially, or in some cases completely, offset the annual management fee (TER). For example, iShares delivered 40 additional basis points (bps) of performance to its EURO STOXX 50 ETF and 148 extra bps to its MSCI Turkey ETF--more than covering their TERs of 15 bps and 74 bps, respectively. With the introduction of the 60/40 split, we might see even better enhancements going forward, depending on borrowing demand and associated fees.
The extent of securities lending activity varies greatly across iShares ETFs. Although iShares can lend out up to 95% of the securities held within its in-kind ETFs, the actual utilisation is much lower in practice.
For example, the iShares MSCI Turkey ETF, in the last twelve months has had an average lending utilisation rate of 37%--while the maximum it has lent out over this same period is 82%. During the trailing twelve month period, iShares EURO STOXX 50 has lent out 15% of its underlying securities on average and has lent out a maximum of 50% in the same period. In general, there is more borrowing demand from short-sellers for small, illiquid and hard-to-find securities than for large cap securities.
The new 60/40 revenue split also means that investors will be better compensated for the counterparty risk they are assuming as a result of this securities lending activity, beyond the safeguards that are put in place by BlackRock. Indeed, investors should always remember that these programmes are not risk-free. There is always a chance that a borrower will default on the commitment to return the lent securities.
To mitigate this risk, BlackRock takes collateral greater than the loan value (see table below for collateral margins), and revalues the loans and collateral on a daily basis. This risk management policy is key to minimising the risk associated with securities lending.
We view iShares’ decision to pass more lending revenue to its ETFs as a very encouraging development. However we can’t help but ask if iShares couldn’t be more generous and give the funds 100% of the income. After all, fund shareholders are ultimately assuming 100% of the risk associated with this practice. In the US, Vanguard—the third-largest ETF provider—splits 100% of the revenues it generates through share lending with fund investors. Undoubtedly, this can serve to further improve investors’ end returns, helping to offset both explicit carrying costs (most notably the TER) and other sources of tacking error unique to physical replication funds.
On an industry-wide basis, we expect an increasing number of investors to call for better transparency on securities lending, especially after the recent commitment on the part of a few synthetic ETF providers --including Lyxor, db x-trackers, Credit Suisse and iShares--to disclose their swap positions and the composition of their collateral/substitute baskets on a daily basis. These providers have set a precedent, and now it might be just a matter of time before physical ETF providers, including iShares, take the initiative to provide daily disclosure of the amount of securities on loan, the type of collateral held in place and the identity of the borrowers. Currently, this information is only available in annual reports and upon request.
