Rising short interest, and an increasing thirst for fees, could prompt a rise in securities lending by mutual funds. The practice is good for the funds, but it may not be good for your clients.
Investors who sell securities short are betting that prices will fall. To sell short, you need to borrow the securities and sell them in the hope of buying them back later at a lower price. One source of securities for short sellers: mutual funds and ETFs.
The loans are securitized, with collateral equal to 102% to 105% of the value of the borrowed securities, according to the Investment Company Institute, the funds' trade association. The collateral is usually cash or high-quality short-term securities.
Funds can call the loans at any time, and can invest the collateral for additional interest. In addition, the borrower must pay the lender the equivalent of any dividends paid out during the loan.
For some fund companies, securities lending can be a significant boost to returns, especially since securities in high demand command higher interest rates for the lender.
Brad Lamensdorf, co-manager of the actively managed ActiveAlts Contrarian ETF (SQZZ), often buys stocks of companies with high short interest, betting on a rebound when short-sellers buy stocks to close out their positions.
"If I can get 4% interest on 50% of my position, that's an extra 200 basis points," he said.
Index funds are significant lenders, and returns from securities lending can boost their returns. In 2014, index funds and ETFs gained about 3 basis points, according to Vanguard. Small-cap and international funds gained about 10 basis points — big gains when index funds often charge 25 basis points or less. As mutual fund fees fall, securities lending becomes an increasingly tempting way to offset those declines.
Defaults on securities loans are rare. BlackRock, which has had a securities lending program since 1981, says it has suffered three defaults since then, all of which were covered by collateral.
The drawbacks? One is if most portfolio lending is used to build short positions in a security. If the borrower is correct, the lender will face a loss on the position. The loss on the position might hurt the fund more than the interest gained on the loan, wrote Detlef Glow, head of Lipper EMEA Research.
Another problem is how the income from securities loans is divided.
"Even though the fund and therefore the investor bear the full risk of the default of a borrower, the lending fee is normally shared between the investor and the fund promoter," Mr. Glow wrote. "Securities-lending activities offer a free lunch to fund promoters, since they get return without bearing any risk."
Finally, there's the issue of investing the collateral. While many funds invest the loan collateral in relatively low-risk money market funds, others attempt to increase their returns by investing in riskier assets. During the 2007-09 financial crisis, some cash management pools lost more money in their collateral investments than they did through the loans themselves.
"The episode spotlighted an underappreciated reality: The most significant risk in securities lending lies not in the lending itself, but in the reinvestment of the cash collateral," according to Vanguard.
As the stock market has risen this year, so has short interest, which is the amount of stock shares sold short and not yet repurchased. As of March, short interest on the New York Stock Exchange was $15.1 billion, up from $12.6 billion in December. Given the increase in short interest — and the continuing squeeze in fund expenses — it's likely that securities lending in the industry will rise.
You can find out a fund's securities lending policies in its prospectus and its statement of additional information.