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If you own units in a mutual fund or exchange-traded fund, there is a good chance the managers are lending out the securities held in trust for you. In most cases, the borrowers are hedge funds who want to short sell the securities.
This may seem somewhat at odds with investment funds’ fiduciary duty to maximize fund-holders’ returns. Short selling of securities tends to put downward pressures on prices. Carried to an extreme, it could support “bear raids” of the kind alleged to have occurred in U.S. financial stocks during 2008.
The fund companies also collect lending fees from the borrowers of the securities. This brings up a second issue. Many funds do not rebate all, or even part, of those lending fees back to unit holders. They keep them in whole or part for themselves.
A third issue is risk. Lenders of securities ask for collateral, usually 102% to 105% of the value of the loaned-out securities. That sounds prudent if the collateral is low-risk government bonds. But these days, securities lenders accept collateral of less quality.
“Today… some beneficial owners meet borrowers’ demands by accepting, in addition to government securities, bank paper, corporate debt, equities and other securities as collateral,” notes State Street Canada securities lending manager Don D’Eramo in an article appearing in Benefits Canada.
This presents the risk of losses from i) borrowers being unable to meet margin calls if their collateral falls in value, and ii) default of counterparties on obligations to return securities. And these are losses that fund holders end up bearing. The risk is borne by fund holders while the gains go in whole or part to the fund.
Many pension plans also engage in securities lending. An exception is the Ontario Teachers’ Pension Plan, which discontinued its securities-lending practice two years ago. It did not like giving up its voting interest in shares loaned out. Now it has more leeway to boost the value of its plan members’ holdings through shareholder activism.
For a long time, securities lending has gone on behind the scenes. Although fund companies have disclosed the practice in annual reports and elsewhere, investors have largely remained unaware or unconcerned. That state of affairs could be changing as the practice becomes more significant in terms of revenue generation and impact on markets.
Indeed, a leading personal finance columnist in the U.S., Jason Zweig, recently wrote a Wall Street article spotlighting securities lending, ‘Is Your Fund Pawning Shares Off You?’. He reports that “securities lending generated about $1.4 billion (U.S.) in gross income (before collateral reinvestment) at U.S. mutual funds last year….”
Zweig was able to identify only a few U.S. funds “that rebate all securities-lending income (net of expenses) back to the funds that generated it,” notably T. Rowe Price Group and Vanguard Group. Most of the others, presumably, keep some or all of the lending fees for themselves.
He also uncovered a fund that kept its collateral in an investment vehicle that was not registered with regulators, owned by the fund itself, and charged a management fee on the invested collateral. Another fund had placed collateral in a bank account, which was then invested in the securities of Lehman Bros. (and subsequently lost when the latter went under).
Securities lending is not necessarily a bad thing. It may promote short selling but the latter can, in moderation, have benefits such as providing greater liquidity to financial markets. And if the income is fully passed on to fund holders (after expenses), it can lower management expense ratios or add 0.5% to 1% annually to fund returns.
Nevertheless, one does wonder if securities lending is in danger of becoming another case of financial innovation taken to a dangerous extreme. Regulators perhaps need to be on guard that competition among investment funds doesn’t drive them into overly risky or unethical practices.
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