iShares removes stock lending limit

The new rule is a U-turn on the 50 per cent limit imposed by the company in 2012, when it said customers wanted it to put a cap on the quantity of assets it was willing to lend. It also puts it at odds with peers, which have generally been restricting the practice. Deutsche Asset Management restricts securities lending to half of assets held and Source and ETF Securities do not lend out any of the assets held by their ETFs.

Securities lending is a widely used practice among ETF providers, but has come under the spotlight this year from regulators who believe it is injecting risk into the financial system. The process works by ETF providers loaning out the stocks they hold in exchange for collateral, usually a basket of different stocks held by that third party. The ETF provider charges a fee in return for the stock loan, which it can use as income to boost the performance of the ETF.

Proponents of stock lending claim it can boost returns and argue that the practice allows an ETF to artificially reduce tracking error by smoothing out ETF returns when markets are closed. But others argue that it increases third-party risk and means investors are left holding different assets within the product to the ones they expected.

Ben Seager Scott, director of investment strategy at Tilney Bestinvest, says: "I am generally opposed to securities lending on exchange-traded products (ETPs) as it adds complexity and opacity to products that are otherwise designed to be simple and transparent. It also adds the potential for counterparty risk, which again is a risk I avoid as much as possible.

"The ETP industry in Europe has come a long way in the past few years to cut back on securities lending. I'm surprised and very disappointed that iShares, which is usually a trendsetter in the industry, appears to be moving in the opposite direction."

Mr Seager-Scott is particularly concerned about lower-risk ETFs. He points to iShares UK Gilt 0-5yr UCITS ETF (IGLS), usually considered a low-risk asset class, which has, on average, been lending out almost half of its holdings.

He says: "It appears to be holding higher-risk equities as collateral, including European banking equity. Not only are these considered higher risk, but there's a strong likelihood that in the event of a market shock the correlation between the collateral and the index constituents would be strongly negative."

BlackRock argues that consumer demand has prompted its move to scrap the securities lending limit. The company says the collateral held by the ETFs will always be of high quality and remain highly liquid and argues that the value of the collateral will be greater than the value of any stock loan. The company also indemnifies investors against borrower default.

Lyxor also engages in securities lending. In an April report, the company stated: "By reinvesting the revenues from securities lending, physical fund managers can improve the degree to which the ETF tracks its benchmark index. The risk is that the institution borrowing the securities could default, in which case the securities could be lost, and the fund value would suffer. However, with adequate collateral and tight management this risk can be mitigated."

Will the change affect you?

Most investors with iShares ETFs will not see any change to their products and the company now updates details of securities lending on its website daily. A spokesperson said: "For the vast majority of funds, removing the utilisation limit is unlikely to impact the value of securities on loan. For iShares ETFs domiciled in Europe, the average amount lent has been less than 10 per cent in the year ending 31 March 2015."

Whether you opt for a product that uses securities lending or not is up to you. But before you make the decision think carefully about:

■ How much stock can be lent?

■ Who is the stock lent to?

■ How does the value of the collateral measure up against the value of the stock loan?

■ What is the collateral?

iShares UK Gilts 0-5yr UCITS ETF

12-month lending summary as of 31 March 2015

Top 10 Collateral holdings

Source: iShares

Annualised performance % GBP

Source: iShares as at 30 June 2015