This is the final post in a series of three looking at the potential risks that ETFs may pose to the stability of financial markets. The previous two discussed synthetic and leveraged ETFs. Now we’ll take a look at the practice of securities lending.

Many active traders, including hedge funds and prop traders at investment banks, engage in short selling when the they believe a stock is about to fall in price. For example, if a company is trading at $20, a short seller might borrow shares and sell them on the open market for that price. If the stock falls to $18, the trader can then buy it at this lower price, return the shares to the lender, and pocket a profit of $2 per share (before costs).

Firms that borrow shares need to get them from somewhere, and the most common lenders are mutual funds, ETFs and pension funds, who use securities lending agents as intermediaries. When a fund lends shares to a short seller, it collects a fee for doing so.

The problem

The main concern about securities lending is common to all funds, not just ETFs: namely, the borrower may default on the agreement to return the securities to the lender. While all developed countries have regulations that require the borrower to provide collateral, the strictness of the regulations vary. According to the UK site Fundweb, in Europe “the assets offered as collateral are often less liquid than those that are borrowed. In the event of a market run, ETFs could find it hard to pay back clients if they have large amounts of illiquid assets on their books.”

A second problem applies to ETFs more directly. Unlike active mutual funds that charge fat management fees, index ETFs have low margins. There may a greater incentive for their managers to overindulge in securities lending—and therefore take greater risks—in order to squeeze out higher profits.

There is also a question about the fairness of securities lending. The revenue collected from borrowers is typically shared by the lending agent (which may be affiliated with the fund provider) and the fund itself. Industry standard seems to be that investors in the fund get about 50% or 60% of the revenue, which can offset some of the management fee and lower the fund’s tracking error. That’s a good thing, but investors might reasonably ask whether their share should be higher. After all, they own the shares, and they are the ones taking all the risk when they’re lent to a short seller. Why, then, are they only getting half the reward?

What Canadians need to know

As with the concerns about synthetic ETFs, the major problems with securities lending are in Europe, where the practice is more common and less strictly regulated. Canadian mutual fund regulations require that no more than 50% of a fund’s securities be on loan at any time. The collateral must be of high quality and must have a value at least 102% of the loaned shares.

You can learn the extent of an ETF’s securities lending by checking its Management Report of Fund Performance and its financial statements (look under “Statement of Operations”), both of which you can find at SEDAR. In most cases, you’ll find that the revenue is very small. For example, the iShares S&P/TSX 60 (XIU) has about $10 billion in assets and earned all of $157,000 from securities lending in the first half of 2011. The iShares DEX Universe Bond (XBB), with $1.7 billion under management, raked in a whopping $25,000 during the same period.

iShares explains in its financial statements that they split securities lending income 60-40, with the larger share going to the fund and the smaller going to the lending agents. The lending agents are affiliates of BlackRock, which owns iShares. You can read more about iShares’ securities lending practices in page two of this document.

Claymore employs a third party, CIBC Mellon, as its securities lending agent. In an email to me, Claymore president Som Seif explained that their collateral requirements are even stricter than what the regulators require. They insist that all collateral be valued at 105% of the securities loaned, and that “this amount must be in cash and cash equivalents, and cannot be invested in riskier securities in effort to generate higher returns.”

Unfortunately, Claymore does not disclose how securities lending revenue is divided between CIBC Mellon and the funds themselves, saying only that “it is in line with other players.” From looking at the ETFs’ financial statements, it seems to vary from fund to fund. For example, the Claymore Canadian Financial Monthly Income (FIE) shows some revenue from securities lending (about $40,000 annually). However, several others—including the Claymore Canadian Fundamental (CRQ), Claymore BRIC (CBQ), and Claymore Equal Weight Banc & Lifeco (CEW)—engage in significant securities lending, but no revenue from this activity appears in their 2010 financial statements.

The most generous ETF provider in this respect is Vanguard. According to its website: “Unlike other firms that allocate a significant portion of lending revenues to their management companies, Vanguard returns all lending revenues, net of broker rebates, program costs, and agent fees, to the funds. Other securities lenders may divert up to 50% of the revenues derived from their securities lending programs.”

With Canada’s strong regulatory framework and the relatively small amount of securities lending that goes on in ETFs, I don’t think the practice is unduly risky. However, as an investor I would demand full transparency when it comes to revenues: since the unitholders own the stocks in the funds, they have a right to the majority of the profits. Or at the very least, they have the right to know who receives the revenue, after which they can decide if they’re comfortable with the arrangement. Jason Zweig of The Wall Street Journal made these arguments back in 2009 and again last month.

This is especially true if the ETF in question has a significant tracking error. I expect a fund to trail its index by an amount equal to its management fee, but if the tracking error is more than that, then revenue from securities lending might be used to close that gap. If it ends up in someone else’s pocket instead, then that tells you something about the fund manager’s priorities.