Exchange traded fund providers have utilized securities lending techniques to help generate extra income with their fund products. However, two pension funds have alleged that BlackRock ‘s iShares unit is taking excessive profits.

The pension funds claim that iShares generated $397 million in securities lending fees between 2011 and $157 million in the second quarter of 2012 and kept 40% of the profits, reports Jason Kephart for InvestmentNews. BlackRock, though, maintains that it keeps just 35% of net securities lending. [BlackRock’s iShares Sued Over ETF Securities Lending: Reports]

In comparison, Vanguard returns 100% of its revenue from securities lending to the funds while State Street Global Advisors returns 85%, according to the report.

Funds engage in securities lending as a way to generate extra revenue. The holder temporarily transfers the security to another investor in exchange for collateral, such as cash or other securities equal to 102% to 105% of the shares’ value. If the ETF needs to sell stock, it can take it out of the borrower. If the borrower is unable to deliver the shares, the ETF uses the collateral. [How ETF Securities Lending Works]

According to derivatives research firm Markit, funds can loan their underlying shares to borrowers for a profit of about 40 basis points.

“The complaint is without merit, and we will contest it vigorously,” spokeswoman Melissa Garville wrote in a note. “IShares has a long record of delivering the returns our ETF investors expect, and securities lending is one of the tools we use to help ensure our funds efficiently track the performance of their underlying indices.”

Mike Rawson, ETF analyst at Morningstar, points out that securities lending allow larger ETFs to outperform their expense ratio.

“It can have a significant impact,” Rawson said in the article.

Securities lending has been associated with counterparty risk. If a borrower, for whatever reason, does not return the shares, the ETF would be left in a short squeeze.

For more information the ETF industry, visit our current affairs category.

Max Chen contributed to this article.

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