Nadig: iShares’ Change Good For Investors

BlackRock makes a subtle change to its securities-lending program that all investors should cheer.

Reviewed by: Dave Nadig
Edited by: Dave Nadig

BlackRock makes a subtle change to its securities-lending program that all investors should cheer.

Investors seem to really care about securities lending, and they should.

When it's done well, it can add significant revenue to an ETF portfolio, offsetting—and sometimes more than offsetting—the management fees of the funds. Done incredibly poorly and in violation of regulation, it could theoretically cause portfolio hiccups.

Luckily, "incredibly poorly" and "in violation of regulation" are two phrases I don't think I've ever had to use in my 20 years in the ETF market.

This week, BlackRock quietly updated its securities-lending policy. You may recall that BlackRock in the past has taken some on this front in the form of a lawsuit. That heat mostly comes from the fact that BlackRock has the temerity to want to make a little money from being very, very good at the securities-lending business. "Sec lending" for iShares funds is actually managed by an internal group at BlackRock, which is paid 35 percent for any revenue collected for its services.

The headline news today is BlackRock is changing that "sec-lending" fee to 30 percent for U.S. equity ETFs, and 25 percent for all other ETFs.

On the surface, it's a pretty marginal change, and one that definitely favors investors. If you're a shareholder in the iShares Russell 2000 ETF (IWM | A-84)—the poster child for successful securities-lending programs—you're now collecting 70 percent of the proceeds, not 65 percent.

But as I said back in February of last year when the lawsuit came out, this actually misses a key point in the discussion, and one that leads to terrible apples-oranges comparisons.

Consider Vanguard's position. The company can't get any more Boy Scout than it already is—it gives 100 percent back to the fund. One-hundred percent of the profits, that is.

Imagine you and I were running lemonade stands. I offer to donate 100 percent of my profits to charity, and you offer to donate 70 percent of your gross revenues to charity. How are our incentives different? Well, first of all, I know—with certainty—that some amount of money from your lemonade stand is going to a good cause. But my lemonade stand might be a bust. And frankly, what do I care? After all, I'm not going to keep any of the change.

That's the position these two huge fund sponsors are in.

If iShares runs its "sec-lending" group really well, it benefits. If it's inefficient, it will lose money. In either case, the ETF gets a cut. In Vanguard's case, the company pays for "program costs and agents fees" and whatever's left is whatever's left.

Vanguard goes one step further and states that it's only ever going to loan securities when it's super in-demand and thus paying high rebates. The theory there is it minimizes risk—which is already miniscule, with at least 102 percent cash-collateral in the bank—and maximize returns.

Is there a "right" answer here?


Not really.

I have the strong suspicion that BlackRock's "gross" cut and Vanguard's "net" cut would come out to surprisingly similar numbers for the same security out on loan. As an investor, it's important to understand that you can measure this, but only indirectly.

Any revenue collected from securities lending rolls into your bottom-line performance. It comes onto the books as "income," which is generally used to offset "expenses." And the biggest expense in any ETF is generally the management fee. That shows up in better performance.

Consider the rolling one-year tracking difference statistics for the two most-lendable portfolios at each firm. Their small-cap funds:

iShares Russell 2000 (IWM)Vanguard Small Cap (VB)
Expense Ratio0.24%0.10%
Median Tracking Difference0.02%0.07%
Max Tracking Difference0.08%0.11%
Min Tracking Difference-.01%-.09%

These statistics come from our analytics platform. They measure the one-year performance of the fund's NAV versus the index it's tracking over 252 observations—a rolling two-year window.

Your expectation is that a perfectly managed fund would trail its index by exactly its expense ratio. So you'd expect IWM's median tracking difference to be -0.24 percent, and VB's to be -0.10 percent.

In fact, both funds do significantly better, and while there can also be some portfolio optimization at work, history would suggest it's almost entirely the sec-lending revenue that makes the difference here.

In Vanguard's case, on a median year, it's doing 17 basis points better than you'd expect. In iShares, it's doing 26 basis points better than you'd expect. You can also tease out the difference in approach here.

In the "worst" year for Vanguard, it trailed its index by almost exactly its expense ratio, implying that was a window of time where there wasn't much money to be made, and that it has a super-conservative lending approach. In iShares' worst year, it still managed to earn 23 basis points.

So what's the takeaway here?

Securities lending can make an enormous difference in returns. I don't know about you, but in this market, I'm not leaving 25 basis points lying on the floor, ever. I'm bending over and picking that quarter up off the street.

The latest move by BlackRock is just one more reminder that investors have to look past headline expense ratios and into the details of exposure, management, and indeed, securities lending.

At the time this article was written, the author held no postitions in the security mentioned. Contact Dave Nadig at [email protected].

Prior to becoming chief investment officer and director of research at ETF Trends, Dave Nadig was managing director of Previously, he was director of ETFs at FactSet Research Systems. Before that, as managing director at BGI, Nadig helped design some of the first ETFs. As co-founder of Cerulli Associates, he conducted some of the earliest research on fee-only financial advisors and the rise of indexing.