#Haters - What's Your Problem With Stock Lending?

For the better part of the past month, the number one story on ETF.com Europe has been Rachael Revesz’s article titled iShares Scraps 50% Stock Lending Limit.  People can’t seem to get enough of it.

The point of the story is that iShares has “scrapped its limit on stock lending for all of its physically replicated exchange traded funds (ETFs) in an attempt to boost profits”.  Previously, iShares would only lend out 50 percent of a fund’s portfolio at any given time; now, it can lend out all of it.

Our article points out that the move from iShares goes “against the tide,” running counter to UBS’ decision to institute a lending cap in May 2014 and HSBC’s decision to stop lending altogether in December 2013.

The implication is that iShares is a wonton risk taker, finding ways to line its own pockets by putting shareholder money on the line.

A quote in the piece from Ben Seager-Scott, director, investment strategy at Tilney Bestinvest, sums up the prevailing wisdom: ““I do accept some of the arguments of the providers that it provides further revenue to the funds that reduces the effective cost but from my point of view it adds unnecessary complexity to products that are supposed to be simple and transparent.”

I don’t agree with that view at all. As an investor, I want my funds to lend shares aggressively. And you should too.

Theoretical Risk Vs. Proven Benefits

To understand why people get upset about share lending – and why they are crazy to do so – you have to understand how it works.

Let’s say you have a fund like the iShares Core Euro Stoxx UCITS ETF. It holds an index of big cap European stocks like Sanofi, Bayer and Total. Sometimes, there are investors who want to short these stocks. When they do, iShares will lend them out to that investor. In exchange, the investor will have to pledge collateral – typically stocks, bonds or cash – and also pay the fund a fee. For iShares ETFs, the fund’s investors collects 62.5 percent of the proceeds and BlackRock takes 37.5 percent.

The money that comes in from securities lending can be a meaningful benefit for the fund: In the case of the Euro Stoxx ETF mentioned above, iShares says securities lending is adding about 0.02 percent a year to the fund’s return. That’s 20 percent of the expense ratio (0.10 percent).

Meanwhile, these arrangements have no impact on the fund’s performance, aside from the benefit of collecting that fee. The fund retains the economic interest in the performance of the stock it lends out.

So what’s the downside? Well, when the fund loans securities out to another investor, there is a small chance that the borrower will default and not be able to return those securities at a later date.

Fund companies aren’t stupid, though; they put a number of safeguards in place in the off chance this happens.

For one, the loans must be collateralized with stocks, bonds or cash; in fact, they must be over-collateralized, to the tune of 102 percent to 120 percent of the portfolio value.  There are various restrictions on the collateral to ensure it is liquid and not overly concentrated in a single issuer.

For two, the creditworthiness of the borrower is monitored.

For three, in BlackRock’s case, the company actually indemnifies the fund in the event of borrower default.  If there’s a shortfall, BlackRock will make the fund whole.

In other words, for a fund to lose any money in a securities lending transaction, the following things must happen all at once:

1) The borrower must default on the loan.

2) The collateral that the fund holds – typically set at 102 percent-120 percent of the value of the loan, and monitored carefully – must be significantly more in value than the security it is pledged against, so the fund can’t recoup 100 percent of the value.

3) BlackRock must go bankrupt.

Additionally, you have to not notice that any of this is happening. Because if it looked like BlackRock might go bankrupt and the financial system might collapse, you can simply sell your fund and be on your way.

Massive Benefit, Minor Risk

I love that people have forced ETF companies to shed light onto their securities lending process. Unmonitored, it’s a source of potential abuse and risk.

But for the most part, those who fret about it now should don tinfoil hats and buy gold coins. BlackRock started lending securities in 1981. Neither the company nor fund shareholders have ever suffered a loss: not in the 1987 crash, the Asian crisis, the Internet bubble, the financial crisis, the Greek crisis, or anywhere else.

Meanwhile, funds like the Eurostoxx ETF are cranking out an extra 0.02 percent in returns each year. That’s about €225,000 each year accruing to investors. Multiply that out by the €2.7 trillion in global ETF assets and you’re talking about hundreds of millions of euros piling up in investor bank accounts.

That money is very real.  Compared to the theoretical risks, I say sign me up.