Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Most investors don't realize that many mutual funds and exchange-traded funds loan out the securities in their portfolios. Joining me to discuss the practice of securities lending is Adam McCullough. He is an analyst in Morningstar's manager research group.
Adam, thank you so much for being here.
Adam McCullough: Thanks for having me today.
Benz: Adam, you authored a white paper that we published and linked to on Morningstar.com about the practice of securities lending. Let's just start by talking about what it is, because I think for many mutual fund investors and ETF investors, they may be quite unaware that this is going on at all. So, what's happening with securities lending?
McCullough: Absolutely. It is a backwater of finance in it is just, as it sounds, is the lending out of securities from a portfolio to borrowers who want to either borrow the stock to hedge, to short, or to take advantage of an arbitrage opportunity. And so, mutual funds and ETFs, particularly those that track broad indexes, are natural lenders of securities because they have such a broad array of securities, and they are passively owned. So, they are not going to be buying and selling these securities.
What these funds can do is they can lend out those securities to borrowers that want to short sell them or do other things with them and earn income on those that can help offset their fee, and in some cases, that offset can be meaningful and offset a majority of the fee that you would pay as an investor in that fund.
Benz: That's one of the benefits, which I want to get to. But before we get to that, I think, some people may have become aware of securities lending during the financial crisis where you had some funds run into trouble with the practice. Let's talk about how the risks can come home roost in some cases.
McCullough: Absolutely. So, securities lending did earn a checkered reputation during the financial crisis. Most of those losses though were from pension and endowment funds. Our focus here is more on the mutual fund and ETF side, which are governed by the SEC under the 1940 Act. The restrictions on how you reinvest the collateral that the borrowers post when you lend out the securities is much more stringent …
Benz: So, the fund company takes in the borrowers' assets, loans them the securities and so, the borrower has to give you some collateral. That's what you are reinvesting to earn an income stream. That was the problem spot?
McCullough: That was the problem spot. So, just to back up, there's two risks. When I lend out a security--let's say that you are lending me a security, the risk is, one, that I'll default on that security. I won't return it back to you.
Benz: That would be bad.
McCullough: That would be bad. In the U.S., what has to happen is, I have to post collateral to you as you lend out the stocks. Say you lend out $100 of Tesla stock to me, I post to you usually cash collateral to the tune of $102 per $100 of stock that you lend me.
Benz: I get to invest that?
McCullough: Then you take that, and you can invest that to earn additional income on the cash that I post to you as collateral for the lent security. As a lender of securities you stand to earn, one, the lending fees--so that's you lend the stock, there's a fee associated with that based on supply and demand--and you also earn the income from reinvesting the cash collateral.
During the financial crisis, what we saw was there were losses from the cash collateral being reinvested too aggressively and seeing losses from that reinvestment rather than the default risk associated with lending me that security because the collateral could usually cover the losses of any defaults.
Benz: So, you say though mutual funds, because they are better regulated than perhaps some of these other institutional entities that you think there's less of a risk for them?
McCullough: I would say, even more so today there's even less of a risk because the SEC has upped the quality, the liquidity, and the duration standards of the cash requirements the collateral has to be invested in. So, the risk today is even smaller. And I think just from the nature of this all happening during the crisis is that there's response from regulators, there's more transparency into the practice and people know now that this is a risk that can happen. And so how we always fight the last war, I think now this has been an issue that's been addressed, and it won't be as big of an issue going forward. So, the risk is smaller today, but the benefit is still there for mutual funds and ETF investors.
Benz: Let's talk about that benefit. It sounds like it would read down to me as an investor not just to the fund company, right? So, it's not necessarily the fund company's profits but I as an investor may benefit from the practice of securities lending?
McCullough: Right. Absolutely. What usually happens is, is the fund company will have a lending agent that goes out and finds borrowers so that this fund company can lend its securities to those borrowers. This agent as a part of its payment takes a cut of the fee that is generated from lending out these securities.
In most cases, in the U.S., for passive fund sponsors, they use a third-party agent. Think of the big custodial banks like Bank of New York Mellon, Northern Trust, State Street. It's a handful that use their own lending agent, think of BlackRock, Vanguard, Fidelity on its bond side. So, in those cases, the fund company will be earning that cut of the revenue that it generates from securities lending. It's the third party affiliated of the fund company. So, it is at arm's length, but most of the income from securities lending is passed back to the fundholder and is seen on the annual report of the fund as securities lending income. So, usually, we see 70%-plus of that passed back to the fundholder.
Benz: You unpacked fund family by fund family in your research which fund companies tend to do a better job of sharing some of those revenues with fundholders to lower expense ratios.
McCullough: That's right. It's interesting. Of the three fund companies that manage their own programs, BlackRock actually takes the most of the sec lending revenues. So, it's taking 30% from U.S. equity funds of the gross securities lending revenue and passing along to fundholders 70% of that. Fidelity also manages its own program on the bond side, and it passes along 100% of the securities lending revenue to its bond fundholders. State Street is right in the middle. So, it charges 15% of the gross securities lending income as a part of its fee for providing these services and matching borrowers and lenders of securities. For the rest of the fund companies that use independent third-party securities lending agents, the split is between usually 20% and 10% of the gross securities lending income generated for the fund.
Benz: That percentage goes to the fund company?
McCullough: It goes to the securities lending agent. So, then you'd have 80% to 90% of their revenue is passed back to the fund and fundholders.
Benz: Got it. So, say, I hold an index mutual fund and I want to do my homework on, well, what are the practices going on here in terms of securities lending if I want to do my due diligence. How would you suggest investors go about that?
McCullough: There's three things I think to be aware of. The first one, as we just mentioned is, what is the fee split. That's going to be consistent through time. It's like if you invest in a fund and it's cheap, that's going to be a persistent edge you have by investing in a cheap fund.
Benz: And that's documented, right, in my shareholder literature, what that percentage is?
McCullough: Exactly. So, it's actually broken out in the statement of additional information where it goes from gross securities lending income to net securities lending income. It provides a line item by line item basis of what you are paying for that revenue generated. That's the first thing is the fee split. The second thing is the benefit of the income to the fund. So, usually small-cap funds can generate more securities lending income because they hold securities that are hard to find in the market.
Benz: So, they can charge a premium for lending?
McCullough: Exactly. So, all the lending fees are based on supply and demand in the market. So, it's usually harder to find small-cap names just based on the supply issue. On average, small cap stocks command a higher lending premium than large-cap stocks. Usually, small-cap funds will be able to offset more of their fee with securities lending revenue than large-cap stocks. Looking forward, the historical offset or the revenue pass-through is a good indicator of it might be in the future, but it's not always consistent.
Benz: Is this something that you and the team write about or plan to write about in your research reports of actual individual funds?
McCullough: We do cover it in our research reports. We usually look at the tracking difference between an index mutual fund and an ETF and its fee. And so, usually, if the fund is able to track the index by an amount that's less than its fee drag--so, say, that a fee charges 20 basis points over the course of a year, if the fund is able to track that index by an amount less than 20 basis points, then that's usually an indication that it's using securities lending income to offset that fee drag. And that is something that we do write about. Also, going forward, I think that Morningstar is looking into collecting these data points for our products as well.
Benz: Adam, really interesting research. Thank you so much for being here to share it with us.
McCullough: Thanks for having me today, Christine.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.