Securities Lending: Worth The ‘Risk’

March 08, 2013

What if securities lending just wasn’t all that risky?

On Tuesday, my colleague Spencer Bogart wrote a blog claiming that securities lending comes with a lot of risk but little return.

The blog essentially claims that it’s unfair for the end investor to take on all the risks of securities lending without benefiting from all of the reward. But it misses a very key point: Securities lending is simply not that risky.

First of all, it’s not just anyone who can borrow securities from these ETFs—they have to be creditworthy. Also, each fund can terminate the loan at any time and get the securities back if necessary.

Further, the securities lent out are collateralized at 102 percent of their value or more—iShares requires 102 percent for U.S. securities or 105 percent for international. That means if the borrower defaults or doesn’t give the securities back, the issuer gets to keep that collateral.

Additionally, if the value of the securities goes up, the value of the collateral required rises as well, such that the issuer always has at least 100 percent of the value of the lent securities in collateral.

While Spencer highlighted the fact that the funds then invest that collateral cash in securities that could potentially lose money, he didn’t highlight the fact that the funds invest collateral in short-term instruments—money market funds—which are simply not risky.

Additionally, the benefit of hiring professionals to manage your securities-lending program is that there are professionals overseeing the whole process and making sure collateral isn’t being invested improperly.

If the minimal risk level weren’t enough, the rewards can be greater than you think—especially for issuers that dedicate significant resources to their securities-lending programs.

Let’s look at the iShares Russell 2000 Index Fund (NYSEArca: IWM), which earned over $31 million in securities-lending revenues after fees in the year ended Aug. 31, 2012. Based on its $15 billion in assets on Aug. 31, that means investors earned 21 basis points in returns, taking IWM’s effective expense ratio of 23 basis points almost down to zero.

In fact, if you look at IWM’s returns against those of its underlying index from today’s vantage point, it has actually tended to beat its underlying index, meaning that you’re essentially getting access to U.S. small-caps almost for free.

Now, we can complain that iShares takes a cut of that revenue as a compliment for work well done, or we can compare that to an issuer and fund that selflessly passes all revenues through to the end investor. The Vanguard Russell 2000 ETF (NYSEArca: VTWO) earned $87,000 in securities-lending revenue in the year ended Aug. 31, 2012. Based on its $148.9 million in assets on that date, that’s about 6 bps of revenue—less than a third of IWM’s 21 bps—for the investor.

In reality, that number is actually even lower, since VTWO is only a share class of Vanguard’s Russell 2000 Index Fund—it makes up about 42 percent of the total assets of the entire group of share classes. Assuming the different share classes share in the securities-lending revenue proportionally, that means VTWO holders actually only earned a 2.5 bp benefit from the fund’s securities-lending activities.

I don’t know about you, but I’d take an additional 18.5 bps of yield for a minimal amount of risk any day.

And honestly—it’s not necessarily malicious for an issuer to keep a higher percentage of securities-lending revenues.

Good work merits higher pay, and I’d certainly say manufacturing an additional 21 bps of yield qualifies as good work.

At the time this article was written, the author held no positions in the securities mentioned. Contact Carolyn Hill at [email protected].

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