Pssst! Wanna Borrow Some Shares?

SATURDAY, MARCH 10, 2012

By BEVERLY GOODMAN

Securities lending can be a lucrative source of fund revenue, according to a recent study. But there is a catch.

Article from Barron

Securities lending is one of those Wall Street practices akin to indoor plumbing—when it operates smoothly in the background it performs a vital function, but when it breaks down it can be costly and, well, let's just say highly problematic.

Whether you're invested in mutual funds or exchange-traded funds, you're probably engaged in the practice of securities lending, and, depending on the fund, you are profiting a little or a lot.

Fund portfolios provide an appealing array of inventory for borrowers, and can therefore generate a pretty lucrative lending business. (Just how lucrative is almost impossible to discern; more on that in a moment.) Securities lending is the short-term loan of stocks or other securities to hedge funds and other institutional investors who are borrowing (usually) to short them. When selling a stock short, an investor borrows shares from an institution and sells them immediately on the assumption they will fall in value and can be returned at a lower cost. The borrower pays a fee for the loan, and must provide the fund collateral equivalent to 102% of the loan. So if a hedge fund borrows $100,000 worth of stock, the fund receives $102,000 in cash. Index funds and ETFs are the biggest lenders, since many active managers don't want to facilitate the short selling of stocks or bonds they own.

FUNDS AREN'T REQUIRED TO DISCLOSE their gross lending revenue, though the net revenue (the amount that goes back into the fund) can be pieced together from the balance sheet and income statements. According to one recent study, index mutual funds generate an average of $1.5 million of return per year. Funds with bigger lending programs, however, can see as much as $30 million a year, says John Adams, one of the study's authors and a finance professor at the University of Texas at Arlington. Both figures are deceptively low: Lending revenue, 50% of which must be returned directly to the fund, amounts to an average of five basis points, or 0.05%, of a fund's total net assets. This usually shows up in the form of a lower expense ratio. Since the median expense ratio of an index fund is 0.46%, the study says, lending revenue offsets nearly 5% of fund expenses. "That may not seem like much," Adams adds, "but that's a meaningful difference in a fund's cost and, ultimately, return."

Funds make money off lending in two ways: the fee they charge for the loan, and the reinvestment of the collateral. This is where it gets complicated.

About half the funds use a custodian, such as the BNY Mellon or State Street, to facilitate the lending. That means the borrowing fees are split between the custodian and the fund; clearly, the better the fund negotiates that split, the more its shareholders benefit. But a more disturbing finding of the study points to a potential conflict of interest when the fund uses a custodian it is affiliated with (for instance, sharing the same parent company). According to Adams, if the fund has an affiliation with the custodian, the return the fund sees from the lending program tends to be much lower. "Securities-lending returns are significantly higher when funds administer their own lending programs," Adams says. That includes Vanguard, which has an exemplary program and is one of the few companies that return 100% of lending proceeds to their funds.

VANGUARD SMALL-CAP INDEX FUND (NAESX), for instance, returned an average of 0.17% of assets to the fund annually for six years. The Dreyfus SmallCap Stock Index Fund (DISSX) saw just 0.12% of assets returned in the same period. Dreyfus is owned by BNY Mellon, one of the largest custodians. The Vanguard fund is considerably larger, but still manages a higher return. "Because the disclosure is so bad," Adams says, "there may be a legitimate reason for that type of difference, but we couldn't find it."

"If the fund investors are taking on 100% of the risk, they should get 100% of the return," says Joel Dickson, a principal and ETF specialist at Vanguard. The risk is that borrowers might not return the shares, or that the vehicle in which the collateral was invested runs into trouble—both of which happened to many lenders during the financial crisis. Vanguard keeps its collateral in its own money-market fund.

The upshot, according to Adams: A fund's board of directors might not be doing its job. Fund boards are responsible for negotiating and approving vendor contracts, including any deals made with custodians. The board at iShares, for instance, noticed that the return agreed to with parent and custodian BlackRock was the lowest legally permitted—50%. Two years ago that was adjusted, and 65% of lending revenue now goes back into the funds. "But at their scale, 65% isn't a very good fee split," Adams says.

Another finding: Funds whose directors were paid more than their peers at comparable funds saw less lending revenue than funds with more modestly paid boards. One theory is that high-paid directors are less likely to challenge management.

Out of Stock

Equity funds had average weekly outflows of $677 million in the four weeks through Wednesday, says Lipper. Taxable-bond fund inflows averaged $8.3 billion, and muni funds took in $1.5 billion. Money funds saw increasing outflows, averaging $3.3 billion a week.

E-mail: beverly.goodman@barrons.com


Article from Barron