Invest with Barclays and watch it sell you short

Barclays Puts
ETF Portfolios
To Good Use

Securities Lending Helps
Juice Returns, Revenue;
Potential for Conflicts

By Tom Lauricella
The Wall Street Journal
Friday, February 16, 2007

Barclays Global Investors has become a dominant force in the business of running exchange-traded funds, partly on the appeal of the low fees it charges investors on these mutual-fund-like products.

Another aspect of its business that is less well-known to ETF investors: Barclays actively engages in securities lending -- loaning out the stocks and bonds in its iShares ETF portfolios. The loans are highly lucrative, bringing in millions of dollars a year for Barclays in addition to the fees it gets for managing the funds.

Securities lending isn't new, but it is growing increasingly common in the fund industry. Such lending has particular appeal for ETF providers. The profits can boost an ETF's returns -- and in the world of index funds such as these, a small amount of additional income can make performance appear significantly better.

Demand for borrowed securities has skyrocketed thanks to the growth of hedge funds employing a "short-selling" strategy. In this strategy, investors bet that prices will fall by selling borrowed shares in hopes of replacing them with cheaper ones bought later, and pocketing the difference.

The Securities and Exchange Commission has ramped up its scrutiny of securities lending in general but especially in cases where an arm of the fund-management company also gets paid for helping broker the lending arrangements. There is potential for conflicts arising from the fact that the interests of the fund-management company arm don't always align with the interests of investors. It is in the fund company's interest to take as big a cut as possible from the lending profits, while it is in the interest of shareholders for the opposite to happen.

At Barclays, a unit of British bank Barclays PLC, the loans boost its profit from some of the index-tracking funds by double-digit percentages, typically 10% or so. But in a few cases, the gains are significantly higher -- at its Russell 2000 fund, for instance, securities lending effectively boosted Barclays' revenues from the fund by 50%.

Meanwhile, for ETF investors, the income that iShares funds receive from lending generally increases returns by 0.01% to 0.15%, according to Barclays.

Barclays says it runs its program in the interest of fund shareholders and complied fully with SEC rules when setting up its securities-lending process. It splits proceeds 50-50 between the fund-management company and its iShares ETFs.

The fees Barclays receives "are fair and reasonable," and the agreement benefits shareholders by providing additional income, says James Parsons, a managing director at Barclays.

Barclays isn't the only firm that gets paid for helping its own funds lend out securities: Goldman Sachs Group Inc. and J.P. Morgan Chase & Co. are two other examples. But in relative terms, Barclays gets a bigger boost in revenue from lending than managers of actively managed funds (as opposed to index-tracking funds like ETFs) given that actively managed funds charge higher advisory fees.

Here's how securities lending works: A fund loans out some of the stocks or bonds it holds in exchange for collateral, usually cash. That money is reinvested into a low-risk investment to provide additional returns for the fund.

The lending is typically done through an agent whose job is to find customers needing to borrow. The agent takes a cut of the money earned from the loan. The share kept by agents varies, ranging from 10% to 50%. Many funds use an outside company as an agent rather than an affiliate of the management company.

Among major ETF providers, State Street Global Advisers, like Barclays, is a big player in both the ETF and securities-lending businesses. State Street currently contracts with an outside agent and doesn't get paid to help its funds with securities lending. Mutual-fund giant Vanguard Group also lends securities, using an in-house broker, but says that all the income goes directly back to the funds.

Such arrangements with in-house lending agents have drawn the scrutiny of the SEC. An examination of mutual-fund practices found instances where fund companies may have improperly tilted the bidding process toward in-house lending agents when fund boards were looking to contract out the business.

ETFs have attributes that make them particularly attractive for securities lending. Based on indexes, they hold a wide range of stocks, and the portfolio composition is fairly predictable.

And as ETFs have become more narrowly focused -- some newer ones target tiny corners of the market, such as biotech stocks -- there's a chance that an ETF company will hold stocks sought by borrowers. Typically, international and smaller-company stocks are the hardest to borrow, and thus the most valuable for a lending agreement.

Barclays, which is among the biggest players in securities lending, has been the lending agent for iShares funds since 2003. The staff of the SEC requires that when a fund board considers an affiliate of the management company as an agent, it must comply with several specific requirements, including that fees charged are "fair and reasonable" when compared with outside vendors. Barclays says that its funds followed that process required by the SEC.

In its role as lending agent, Barclays collected $1.5 million in fees on the iShares Nasdaq Biotechnology fund for the year ending March 2006, amounting to an additional 19% above its basic fee for managing the fund (which totals 0.5% of assets). It is a similar story for its Standard & Poor's SmallCap 600 fund, where $1.6 million in lending fees added up to an additional 20% above the management fee.

Barclays also profits off of securities lending on its bond funds. For its five funds based on indexes from Lehman Brothers Holdings Inc., Barclays received $4.4 million in lending fees, equaling a 23% boost above the $18.9 million in advisory fees it earned.

For shareholders, the magnitude of the income boost is much smaller. In the Russell 2000 fund, the bump up in income for 2006 amounted 0.083%, Barclays says.

However, the firm says that additional yield should be compared with the earnings that other fund companies generate for their portfolios through securities lending. In 2005, Barclays says, its securities lending program helped the company's ETFs exceed yields on comparable funds by 16% to 357%. For example, Barclays says that on Russell 2000 index funds offered by other companies, the nearest competitor only earned half as much on securities lending as the iShares fund.

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