Which Funds Benefit Most From Securities Lending

An Inside Look Who understands securities lending?

Registered funds (by which I mean traditional mutual funds and exchange-traded funds) sometimes permit other institutions to borrow shares from their portfolios, in exchange for a fee. What, exactly, is this business? What are its benefits? What are its risks? If you know those answers, congratulations! You understand more about securities lending than your humble columnist did before he read "Securities Lending: An Examination of the Risks and Rewards," by Morningstar's Adam McCullough.

But the topic is obscure and the numbers are laborious to assemble, as funds until now have not filed their securities-lending activities electronically. To create his paper’s database, Adam trudged through 3,000 fund documents. Well, more accurately, Adam and several ants. Happily for us, though, their suffering is our reward.

The Mechanics Sometimes institutions must borrow stocks; typically so that they can short them. (Shorting a stock, to profit from its decline, requires obtaining the security without paying for it.) For that service, the institutions pay a lending fee. Enter funds. They are delighted to collect every spare dollar that they can get.

Profits from securities lending go to fund shareholders, not fund sponsors. As securities lending is an investment activity, its net revenues belong to those who own a fund. The financial gain to fund companies is not immaterial, though. The income from securities lending can mean the difference between beating a opponent on the year or trailing it. That can strongly affect future asset flows.

Funds that benefit the most from securities lending, from a marketing perspective, are those that have the tightest rivalries, wherein only a few basis points separate the group's winners from its losers. Namely, index funds. It makes sense, then, that indexers provide most of the fund industry's loans. Active funds do participate, but less commonly.

How Much? For this reason, Adam confined his research to index funds. He found that most have loaned securities during the past decade. Of those that have used the tactic, some have done so frequently and regularly, while others have picked their spots. The research firm IHS Markit found that, overall, registered funds account for about 25% of total U.S. securities-lending activity.

Of those index funds that do make securities loans, the highest profits by far accrue to those that invest in U.S. small companies. On average, they gain about 10 basis points per year from securities lending. This figure has bounced around a bit, from a low of 6 in 2001 to almost 20 in 2008 (lending income spiked during the financial crisis, when borrower desperation inflated lending rates), but the overall level has remained relatively steady.

Notably, in its 2017-18 fiscal year, iShares Russell 2000 ETF IWM had an expense ratio of 0.20% of assets and securities-lending income of 0.19%. Effectively, then, it cost its shareholders 1 basis point for the year, because the loan revenue almost entirely matched the fund's official expenses. Matching the index's performance after fees becomes easier when a fund pretty much doesn't have fees!

The average annual payoff (again, for those funds that engage in the practice) declines to about 3 basis points for U.S. mid-cap funds, international stock funds, and taxable bonds. It is only a single basis point for U.S. large-company funds, in part because lending fees are lower for blue chips, as their shares tend to be readily available, and in part because many such funds are huge. Even hefty fees can look tiny when expressed as a percentage of assets.

Risks and Prognosis The risks from securities lending are small--they should be, as the returns are as well. (Generating those several basis points of income requires substantial lending volume.)

The borrower provides collateral, so no harm can be caused if the borrower were to skedaddle (which, of course, is highly unlikely). The only real concern is if the lending agent--the third party in the securities-lending transaction--errs when investing the cash collateral. This has occurred several times with pension funds, but only once, by Morningstar's count, to a registered fund: Calamos Growth CVGRX. Its lending agent held the wrong debt (Lehman Brothers) at the wrong time (September 2008).

In general, though, the lending agents for registered funds invest more cautiously than do the lending agents for other institutional investors, owing to stricter regulations (praise the Investment Company Act of 1940!), so collateral losses are highly unlikely.

The biggest concern with securities lending for registered funds is not the chance of loss, but instead the possibility that shareholders have been ill-treated. With many funds, the lending agent is not a third party, but instead a subsidiary of the fund company. Does that subsidiary charge high fees, thereby siphoning to the organization what properly belongs in the pockets of shareholders? A rhetorical question: The answer, of course, is yes. Give enough people motive and opportunity, and some will treat themselves better than they treat others.

Morningstar will be researching this topic more thoroughly over the next couple of years, paying particular attention to the fees paid to lending agents, and whether those deals are arms-length transactions or potentially cozy (and borderline illegal) internal arrangements. More to come on this subject.

Apples and Oranges The good people at American Funds reminded me that when I showed the results for their largest equity funds in last week's column, next to those of Vanguard's and Fidelity's, the other two firms had a 0.25% annual head start. My tables cited each fund's oldest share class. For American Funds, that meant its A shares, which carry a 0.25% annual 12b-1 fee. The Vanguard and Fidelity funds do not levy such charges.

The objection has some merit. For measuring fund-manager performance, American Funds' R6 shares, which have no 12-b1 fees, would been a better choice. On the other hand, those are not the company's oldest share class, and--even more to the point--they are sold through institutions. Oranges, meet apples.

The point remains. There is no fully correct way to compare the returns of load and no-load funds. Whichever path one selects, it favors one side at the expense of the other. What all parties should agree upon is that the mutual fund industry would improve if this debate could no longer occur. Stripping all sales charges out of mutual funds, so that they resemble ETFs, would make all fruits the same.

American Funds desires such a thing. So does Morningstar.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar’s investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.