David Peartree, The Daily Record Newswire
Securities lending is a common practice by mutual funds and exchange-traded funds that deserves to be better understood by investors. The practice can benefit investors by generating revenue and boosting returns. Investors do not generally consider the risks, however, perhaps because most investors are unaware of this practice.
Securities lending occurs when mutual funds or ETFs temporarily transfer stocks or bonds from their fund to another party in return for a fee and collateral. Strictly speaking these are not loans; title to the securities is actually transferred to the “borrower” subject to an agreement to return them later.
The practice has become increasingly important in the global capital markets over the last 20 years and is credited (fairly or not is not the issue here) with improving overall market efficiency and liquidity. The Economist recently reported that over $1.5 trillion in stocks and bonds are on loan at any given time.
Why should investors care? The answer comes down to who takes the risk and who reaps the benefits.
Mutual funds and ETFs lend stocks and bonds from their portfolios to a variety of institutions. Hedge funds may be looking for securities to make a bet on a short sale. Banks may be looking for higher quality securities than they have on their books in order to meet capital requirements and satisfy regulators. Major broker-dealers who are required to maintain a market in a particular security may be looking to fill a gap in their inventory.
Securities lending is a collateralized, short-term transaction between the fund and a borrower. The fund transfers title to the borrower who agrees to return the security either on demand or at a set date. In return, the borrower pays a fee and provides collateral in the form of cash or highly liquid securities such as government bonds.
The collateral must be greater in value than the value of the securities lent. The lender typically reinvests the cash collateral to generate even more revenue.
At the end of the term, the borrower returns the securities to the fund and the fund returns the collateral to the borrower. Investment returns on the collateral might be kept entirely by the fund or shared with the borrower, depending on the deal they struck.
Funds engage in this practice to generate additional revenue and give an incremental boost to returns. Between the fees charged and the interest earned on the collateral, securities lending has been estimated to boost annual returns by between 0.05 percent and 0.13 percent.
While those seem like slim returns, for some index mutual funds and ETFs it’s enough to cover most, or all, of their annual expense ratio. ETFs in particular use securities lending to reduce their tracking error against their benchmark, a common performance measure.
So, both funds and their borrowers benefit from the practice. What could go wrong and what about investors?
One risk is that the borrower defaults and fails to return the securities. This is known as “counterparty risk.” Counterparty risk is one of those terms, often buried in a prospectus, to which many investors give little thought. The recent financial crisis should have changed that thinking.
Hedge funds routinely fail and even household names like Lehman Brothers can default. Other institutions just flat out misbehave with investors’ money.
Theoretically, the posting of collateral should eliminate counterparty risk. Another risk of securities lending, however, is reinvestment risk — the risk that a fund invests poorly the collateral they hold.
Reinvestment risk becomes an issue when funds invest cash collateral too aggressively or carelessly as some funds did during the 2008 financial crisis. Funds that reinvested collateral in Lehman Brothers debt, for example, took a hit. Even reinvestment in institutional money market funds carries more risk than many suspect.
Although it is widely reported that only one money market fund “broke-the-buck” during the 2008-2009 financial crisis, reports by federal regulators have identified over 300 cases where money market funds needed some form of financial rescue. Underscoring the fact that money market funds can fluctuate in value and carry some risk, the SEC recently proposed that prime money market funds used by
institutional investors use a floating asset value rather than the traditional $1 per share stable value.
The risks to investors posed by securities lending may be slight, but not so slight that they can be dismissed. Funds, after all, can loan up to 33 percent of their holdings. Barron’s quotes David Swensen, the manager of Yale’s endowment fund, as criticizing the practice of securities lending with the warning: “Make a little, make a little, make a little, lose a lot.”
What about fund investors? Investors certainly benefit to the extent that the revenue from securities lending is passed along to them by the fund. Fund sponsors vary, however, in how much they share.
Some report passing along all net revenue from lending, others keep a share of the revenue but at least report the split to their investors, while others may not disclose how much revenue they keep because currently they aren’t required to.
Losses are another matter. Some funds will indemnify investors against a borrower default but not necessarily against losses from reinvested collateral.
Fund investors should:
1. Be aware when securities lending is going on in the funds they own.
2. Avoid fund sponsors who won’t disclose their lending practices.
3. Invest with fund sponsors who exercise good stewardship in terms of how much they will lend, how aggressively they will reinvest collateral, and the counterparties with whom they will do business.
Knowledge is power and ignorance carries a price.
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David Peartree, JD, CFP® is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, NY 14625; email david@worthconsidering.com.
