A lawsuit shines a light in a dark corner, but what exactly is
that light going to find? Probably not much.
As reported here (and everywhere else), BlackRock, the issuer of
the popular iShares brand of
, has been sued by a group of Tennessee pension plans for the
structure and fees associated with the ETF securities-lending
My initial reaction on hearing this news, to be honest, was to
yawn. Yes, BlackRock splits its securities-lending revenue at one
of the lowest rates in the business, returning just 65 percent of
topline revenue to the funds whose securities it lends out. But
every time this story comes up, there seem to be apples-and-oranges
First, it's worth actually reading the complaint, but full
warning, it's a long one.
The suit goes into exhaustive detail about the
securities-lending business, the relationship of various BlackRock
subsidiaries and how the whole thing works. It also comes with a
very clear moral angle as well:It flat-out declares that securities
lending, regardless of who profits, is a direct conflict of
interest with long-term investment management.
Here's an example:"Securities lending by any mutual fund
involves an inherent conflict of interest because it facilitates
short sellers who are trying to drive down the price of the very
shares that funds are lending."
While there's some truth to that-short-selling is indeed the
main driver of securities-lending demand-since virtually all large
pools of assets
loan securities, a fund that chooses not to loan is missing the
only opportunity it has to make lemonade out of the short-sellers'
But that's neither here nor there. The main point of the suit is
that the pension funds really think BlackRock is just charging too
much. BlackRock takes a flat 35 percent of all top-line
from securities lending. Vanguard and State Street, by comparison,
take nothing from securities-lending
The real question is this:Does the profit incentive at BlackRock
work for or against investors? Obviously, if BlackRock started
taking crazy risks with its securities-lending program in order to
boost the company's bottom line, that would be bad.
But we don't actually see any evidence of that.
Conversely, since Vanguard and State Street don't have any
direct profit motive to run their securities-lending programs well
(which are generally run through external third parties), well,
that's bad too. Of course, it shows up in performance, which every
A lack of comprehensive disclosure on exactly how much money is
really being made, when and where, makes sussing out these
differences problematic. You can dig deep into a fund's annual
report to get a sense of how well its securities-lending program is
run, but you better come armed with an Excel spreadsheet.
Our advice? Investors should probably focus on their actual
bottom line. Let's look at just one asset class:small-cap value.
It's not a random choice:One of the funds that the lawsuit calls
out as a signal example is the iShares Russell 2000 Value ETF
There's no doubt that iShares did well lending out IWN. In fact,
thanks to SEC filings, we know that BlackRock made exactly
$3,258,389 in fees just from lending securities for that fund in
the year ending March 31, 2012. Based on the 65/35 split, that
means the fund made $6,051,294.
In that same year, the fund paid a total of $10,021,426 in
investment advisory fees. In other words, the securities-lending
program earned back 60 percent of the fee the fund would otherwise
You can see this in another statistic that's a lot easier to
find. In our ETF Analytics system, we calculate 12-month rolling
tracking difference. Over any 12-month period, a perfect index fund
would trail its index by exactly the amount of its expense ratio.
In the case of IWN, that would mean the fund's median 12-month
holding period return should be 37 bps behind the Russell 2000
Value Index. Instead, it's 12 bps behind. The difference?
That 60 percent offset from securities lending.
To see an apples-to-apples comparison, we can turn to Vanguard
Russell 2000 Value ETF (NYSEArca:VTWV), which tracks the same index
as iShares' IWN. In its year ending Aug. 31, 2012, it paid $208,000
in expenses, and earned $87,000 in securities-lending revenue-or 41
percent of its fee.
Again, you can just look at tracking difference to see this in
your bottom line. Over a median 12-month holding period, VTWV has
trailed its index not by its 32 bps expense ratio, but by 15 bps.
It's still better than nothing, but is it better than
From an investor's perspective, you've actually been-in this one
case, to be sure-better off in iShares' product than the cheaper
Vanguard fund, entirely because of BlackRock's extremely effective
Yes, BlackRock charges a higher management fee; yes, it
arrogates 35 percent of the securities-lending profit. But as an
investor, you ended up closer to the index, on average, in the
BlackRock product because the securities-lending program generated
so much more revenue.
Now obviously, not every fund is like this. I'm sure that with
enough digging we could find an inverse example. And for sure, I
have no doubt BlackRock is making a pretty penny running its
But the Tennessee Laborers Local 265 singled out IWN, not me,
and the union is complaining that it thinks a Vanguard-style
program would have been better for them, and that BlackRock's
incentives here are to the detriment of performance.
I'm wondering if they've done the actual math.
At the time this article was written,
the author held no positions in the securities
Dave Nadig at email@example.com.
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