Faulty Math In iShares Sec-Lending Suit

February 05, 2013

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There are different ways to think about the iShares securities-lending program than you might think.

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 ETFs, has been sued by a group of Tennessee pension plans for the structure and fees associated with the ETF securities-lending programs.

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 comparisons.

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 can loan securities, a fund that chooses not to loan is missing the only opportunity it has to make lemonade out of the short-sellers’ lemons.

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 revenue from securities lending. Vanguard and State Street, by comparison, take nothing from securities-lending profits.

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.


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