What if you gave money to a trustee to invest in stocks on your behalf and they later lent them out behind the scenes to short sellers, pocketing for themselves a big chunk of the lending fees? Welcome to the multi-billion-dollar world of securities lending, as practiced by managers of mutual funds, exchange-traded funds (ETFs) and other investment funds around the globe. But thanks to financial regulators, at least in Europe, that practice is facing some big restrictions.
Under the previous rules for securities lending, unit holders still own the shares in the fund’s portfolio and get an investment return, but their interests are compromised in at least three ways. The short sellers who borrowed their shares will be putting downward pressures on their prices, the voting rights attached to the shares will have been transferred away, and unit holders will be on the hook for 100% of any losses arising from short sellers defaulting on stock loans (while trustees take as much as 50% of the lending fees).
It would seem that the trustees involved in this practice are not adhering to their fiduciary duties, but there hasn’t been much of a ruckus over this state of affairs. However, on July 25, European financial regulators issued directives requiring European investment funds to provide greater disclosure of security-lending activities, and to return 100% of securities-lending fees to the fund and its unit holders.
I welcome this move not only on grounds of fairness, but also because it addresses the risk that securities lending could become a destabilizing force. When fund managers take a substantial portion of the lending fees while unit holders remain responsible for the losses, risk and reward become disconnected. If financial history is any guide, fund managers will chase growth through practices that are sometimes questionable—such as accepting collateral of poorer quality or investing collateral more aggressively. The end result could be a ramping up of securities lending to levels that threaten system safety.
Alas, there is many a slip-up between the creation of a regulation and the intended effect. Indeed, this is what Morningstar Inc. ETF analyst Alastair Kellett fears will happen with the order to remit all lending fees to unit holders. This amount is net of costs incurred in lending activities, which opens the door to accounting artistry and other ploys, especially considering lending agents are often affiliated with the investment fund.
In “ETF Rules Do Not Ensure More Money for Investors,” Kellett supports his point by citing the example of the movie business. In Hollywood, “there is no net… [because] studio accountants allocate expenditures and fees in such a way that, technically, even the most popular films seem to break even.”
So let’s hope European regulators realize they have likely fired just the first salvo. They need to remain vigilant and be prepared to amend regulations when the spirit of the new rules is being violated.
North American regulators have some catching up to do.