Securities lending adds return, risk for funds

With rising short interest and low fees, it's an attractive practice for mutual funds and ETFs, but may not be good for investors.
MAY 16, 2017
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.

Latest News

The 2025 InvestmentNews Awards Excellence Awardees revealed
The 2025 InvestmentNews Awards Excellence Awardees revealed

From outstanding individuals to innovative organizations, find out who made the final shortlist for top honors at the IN awards, now in its second year.

Top RIA Cresset warns of 'inevitable' recession amid tariff uncertainty
Top RIA Cresset warns of 'inevitable' recession amid tariff uncertainty

Cresset's Susie Cranston is expecting an economic recession, but says her $65 billion RIA sees "great opportunity" to keep investing in a down market.

Edward Jones joins the crowd to sell more alternative investments
Edward Jones joins the crowd to sell more alternative investments

“There’s a big pull to alternative investments right now because of volatility of the stock market,” Kevin Gannon, CEO of Robert A. Stanger & Co., said.

Record RIA M&A activity marks strong start to 2025
Record RIA M&A activity marks strong start to 2025

Sellers shift focus: It's not about succession anymore.

IB+ Data Hub offers strategic edge for U.S. wealth advisors and RIAs advising business clients
IB+ Data Hub offers strategic edge for U.S. wealth advisors and RIAs advising business clients

Platform being adopted by independent-minded advisors who see insurance as a core pillar of their business.

SPONSORED Compliance in real time: Technology's expanding role in RIA oversight

RIAs face rising regulatory pressure in 2025. Forward-looking firms are responding with embedded technology, not more paperwork.

SPONSORED Advisory firms confront crossroads amid historic wealth transfer

As inheritances are set to reshape client portfolios and next-gen heirs demand digital-first experiences, firms are retooling their wealth tech stacks and succession models in real time.