Fund manager Morningstars ETF analysts have issued a report, which says that while certain strides have been made at enhancing securities lending transparency, there is room for improvement across the industry as a whole.
The report focuses on the latest rules from ESMA, which states that all profits from securities lending by ETFs and other UCITS funds must be returned to the investors in those funds. The rules come into effect in February next year.
The Morningstar survey-based report reveals that around 45% of 184 physical replication ETFs in Europe were engaged in securities lending in 2011. About three quarters of these funds were equity ETFs and one quarter were fixed income ETFs. In terms of actual loan activity, equities accounted for 46% of loaned securities while bonds represented about 54% of assets on loan.
Morningstars report reveals that at present, the majority of providers disclose fee splits as a percentage of gross revenues. Based on this calculation, we found that the portion of revenues returned to the fund could range from 45% to 70% of gross revenue, with the ETF issuer and/or the lending agent retaining the balance, part or all of which is used to cover the operational costs relating to the activity, says Morningstar. Meanwhile, a few providers say they return 100% of the associated revenues, net of costs. They dont, however, currently disclose the amount of these costs.
The report says that while ESMAs new rule may force some providers to pass on more revenue to the fund, others may not do so because they consider that they are currently charging a reasonable amount for the services that they and/or their lending agent are offering. These providers will only change the way they disclose their fee sharing arrangements going forward, stating that 100% of the lending income is returned to the ETF, minus the costs and fees paid to the fund manager and/or the lending agent, which will effectively be equivalent to the share of gross revenue they are retaining today.
Ultimately, whether or not providers choose to rethink their lending fee structures in order to return more income to investors, our hope is that the additional transparency required by the regulator will serve to drive down these fees and costs by shedding some light on them and allowing competitive pricing pressure to come to bear, said Morningstar. This, in turn, will hopefully lead to enhanced fund performance.
There has been progress made over the past year with regards to disclosure standards. Four issuers of physical ETFs, namely iShares, Credit Suisse, UBS and State Street, are now disclosing details of their lending programs on their websites. This compares to only one (iShares) a year ago.
To help investors know if they are being adequately compensated for the additional risk they are assuming, Morningstar believes that providers of physical replication ETFs should post on their websites the following information for each fund: the average amount of securities on loan (in % of AuM) over the trailing one month period; the maximum amount of securities on loan over the last 12 months (in % of AuM), accounting for the variation of the effective maximum on loan levels from fund to fund; the amount and composition of collateral received (this, in turn, will ensure that this collateral is consistently comprised of high-quality, liquid assets, which, in the event of a borrowers default, would be easy to liquidate in order to repurchase the lent securities); the net revenues arising from securities lending activities (in basis points) on a monthly or quarterly basis, together with all the associated costs/fees and the name of the beneficiaries of these fees.
The providers risk management policy should be clearly explained on the website, says Morningstar. The policy should include details on: collateral policy with the accepted types of collateral, level of margins/haircuts required and, in the case of cash collateral, the firms re-investment policy; additional disclosure relates to borrowers identities and the frequent disclosure of who is on the other side of the lending transaction remains subject to much resistance.
(JDC)