Time For ETF Share Lending To Come Clean

One of the great benefits of the ETF structure is its inherent transparency.

The vast majority of ETF issuers publish their fund's holdings daily, frequently in analyst-friendly .CSV files. Even those that don't do this are required to disclose their creation baskets daily, giving investors and analysts at least a general idea of what the fund contains.

Contrast this with traditional mutual funds, which typically release holdings on a quarterly basis and with a lag time of up to two months. Who wants to hand over their portfolio with only a "trust me" in exchange?

That said, there's one aspect of ETFs that still takes place largely in the dark: securities lending.

Most issuers barely acknowledge their lending programs, at least outside of required regulatory disclosures, which are minimal.

The only exception is Van Eck, the firm behind the Market Vectors line of ETFs. Each fund page on Van Eck's website includes securities-lending data, with a level of detail not seen from any other issuer. Van Eck deserves kudos and, more to the point, other issuers need to step up their game.

Securities lending is one of the more arcane subjects within the ETF sphere. For most funds, the effects of securities lending—both good and bad—are inconsequential, a matter of a few basis points here and there.

Sometimes, though, it matters a lot. In 2013, Dave Nadig pointed out that Guggenheim's Solar ETF (TAN | B-36) was throwing off a 5.6 percent yield from a portfolio of solar energy start-ups, most of which had never earned a profit, let alone paid a dividend. But with everyone and their grandmother trying to borrow and short these small, less-liquid solar stocks, the fund was able to collect some handsome fees through its securities-lending operation.

Clearly, the potential for lending income should at least be on the radar when considering an ETF investment. Unfortunately, assessing a fund's lending operations has never been easy.

On our ETF Analytics platform, we track two securities-lending metrics, both found on the “Efficiency” report tab. The first is whether securities lending is active; and, secondly, how lending profits are split between the fund and the issuer. The profit split is set by issuer policy and rarely changes, and we get it by simply contacting the issuer and asking. Most issuers—BlackRock and WisdomTree being the major exceptions—rebate 100 percent of lending profits to the fund.

Determining whether a fund is actively lending securities is trickier...

We get this info from each fund's annual and semiannual reports, which are backward-looking and often several months after the fact. Getting current, forward-looking data is often not possible, even when we have a direct line to the portfolio manager's desk. Most issuers simply don't want to share this information.

Suppose I want to know how much income TAN is making from its lending operations these days—the huge demand to short solar stocks has fallen off since Dave wrote about it, but it's still substantial. How do I go about it?

I could look at TAN's distributions—the fund distributed 1.92 percent over the past 12 months, on a portfolio that yielded only 0.02 percent in dividends. But there are several factors other than lending that could be responsible for this discrepancy, and there's no rule that says lending income must be distributed.

I could also look at TAN's index tracking—we publish tracking statistics on our Analytics platform, under the Efficiency tab. I can see that over the past two years, the fund has beaten its index by a median of 2.60 percentage points annually. That's after a 70 basis-point annual management fee, implying 3.30 percentage of "extra" return, presumably from securities lending.

But, like distributions, there are several other factors (flows, timing of distributions, portfolio optimization) that can affect tracking. In fact, TAN's tracking has been all over the place—not too surprising, given the fund's basket of tiny, illiquid solar stocks—so this technique isn't very reliable at all.

Here's the most accurate method of analysis: Go to Guggenheim's website and download the latest annual report for TAN. It's dated Aug. 31, 2014—almost five months ago. Scroll down to page 30 of the 56-page document. Locate a single line item—income from securities lending: $7,144,031.

Next, hop onto a Bloomberg terminal and pull a year's worth of assets under management data for TAN to find the average for the period from Sept. 1, 2013 to Aug. 31, 2014. In this case, it's $396,152,016. That means the total contribution of lending to TAN's return over this period was 1.80 percent.

It sounds like a pain, and it is. Plus the data is old.

As it happens, TAN has a single competitor: the Market Vectors Solar Energy ETF (KWT | D-34) from Van Eck, the company I singled out for having a very transparent website.

So, how much income did KWT pull in from securities lending in 2014? It's right there on the website: 1.19 percent. Boom, done.

There are other data too. An average of 33.88 percent of the fund's assets were lent out at any one time, with an average collateralization rate of 105.83 percent. The collateral was invested in the Bank of New York Overnight Government Fund, a money market fund. There's a list of borrowers available, as well.

This is all relatively fresh data, as of Dec. 31, 2014. And similar data identifying securities-lending information is available for all of Van Eck's funds that have lent securities in the past year.

What's most exciting to me is the prospect that other issuers will follow Van Eck's lead.

BlackRock, typically a pillar of transparency, does a good job of explaining its securities-lending program on its iShares website. But it doesn't currently provide any specific data, other than a few sample data points from months ago.

A well-run lending program under the right conditions has the potential to more than offset a fund's fee. That's highly relevant to the investment decision.

And while the risks of securities lending—a borrower failing to deliver, simultaneous with the collateral defaulting—are vanishingly small, it's reasonable for investors to expect to know what's happening with their assets.

My message here is simple and clear: It's time for securities lending to come out of the shadows.

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