By: Larry MacDonald
I have been thinking for a while about posting on “securities lending,” the practice where mutual funds and exchange-traded funds (ETFs) lend out securities in their portfolios to mainly hedge funds for short selling. But Jason Zweig’s May 30 column in the Wall Street Journal beat me to it and expresses many of the concerns that I was mulling over.
One was how the lending fees are split between fund investors and fund managers. It appears many funds do not fully, or even partly, rebate the income to fund holders in the form of lower fees or higher returns — even though the securities are being held in trust for fund holders.
Zweig said T. Rowe Price Group and Vanguard Group fully rebate lending fees (after expenses) to fund holders. He named some smaller funds that don’t. The elephant in the room he did not mention in this regard is Barclays and its iShares family of ETFs (presently on the auction block).
They take 50% of the security-lending revenues, which are becoming quite large these days. Barclays’ accounts indicate that the British bank earned £389 million from the practice last year on all its funds under management (of which iShares represents about one-fifth).
Barclays gets a 50% cut because it’s specified in the contract that the board of directors at iShares gave them to manage the lending operations on behalf of unit holders. Couldn’t the board have found managers that would be willing to perform the lending function at a fraction of the fees charged by Barclays?
Indeed, this makes one wonder if the iShares board really is functioning in the interests of fund holders. If the lending function were transferred to an arm’s length party, wouldn’t it be possible to allot more of the lending fees to substantially lowering management expense ratios?
Actually, at present growth rates in securities lending, it’s not inconceivable that ETFs could some day be offered to investors without any management fees – and/or with better performance than the indexes they track. Image that: buying the iShares S&P 500 Index Fund (IVV) with a 0% MER and earning a net return that is a percentage or two greater than the S&P 500. What a concept.
I’ll have more to say on this topic in a column scheduled to appear this Thursday after 4PM (EST) on the home page of Canadian Business (and later, in the column archives). Other issues pertain to the use of the borrowed securities for short selling and the risks in lending securities.
13 Responses to “ Investors: wake up to securities lending ”
Interesting idea.
I heard inklings that Vanguard may ending up purchasing the iShares business as the CVC deal was subject to being outbid by other suitors for a period of time. I wonder if that would factor into the purchase price though…
By Preet on Jun 2, 2009
Zweig’s revelation that the risk that if the person/company does not return your shares when requested, you are on the hook is incredible and shocking. I presume that is the same in Canada.
By CanadianInvestor on Jun 3, 2009
Preet
If Vanguard buys iShares, they may possibly rebate the lending fees to fund holders (as they already do on their existing funds). So we could see much lower MERs at iShares. Now there would be something to rejoice.
By Larry MacDonald on Jun 3, 2009
Can Inves
Yes, the fund holders have the risk of securities lending yet only part or none of the gains (which I discuss in my column to come on Thursday).
By Larry MacDonald on Jun 3, 2009
Fortunately, pensions and mutual funds are looking into alternative ways of lending out their securities that can reduce counterparty risk and increase their returns in a regulated manner.
By A2 on Jun 3, 2009
Wow, here I thought ETF’s were “different” then mutual funds, but it sounds like they play the same tricks.
Dimensional funds apparently outperform their benchmark indexes after fees. I wonder how much of their excess return is attributed to securities lending. If you could only slice off the advisor’s commission you’d be humming along.
By Jordan on Jun 5, 2009
Jordan
Like the mutual fund companies, ETF companies have divided loyalities between fund-holders and shareholders.
By Larry MacDonald on Jun 5, 2009
As is usually the case in finance, sec lending is much more complicated than one would think. Dig into the data, and you’ll find that the iShares funds get as much or more income from securities lending than the Vanguard funds, despite that 50% take. My guess is that the performance on a trading product like security lending is highly correlated to the incentives that the manager has. But no doubt, overall fees should be lower if VG buys the iShares. That doesn’t necessarily translate into better returns though.
By FinanceProf on Jun 5, 2009
FinanceProf
Good point. Fund-owners may “own” the lending fees but unless fund managers have the incentives to generate them, they’ll won’t be overly large. In Vanguard’s case, the incentive seems to come from wanting to be the lowest cost supplier. Maybe fund holders would be happy with that scenario even though it may not generate as much revenue from securities lending as giving additional, monetary incentives to lending agents. One reason for that preference may be to avoid the riskier practises regarding collateral etc. that could result from a more aggressive pursuit of lending. Still, fund-holders may wish to accept these risks and give greater incentives to lending agents but then we encounter the issue of who gets the contract. At Barclays, a non-arms length arrangement exists — one wonders if fund-holders would be better served with an arm’s length agent. Just a few thoughts off the cuff …
By Larry MacDonald on Jun 5, 2009
Hi Larry,
I guess bond ETFs do securities lending too? I ask because iShares XRB has a disappointingly high 0.35% MER. For most funds, that would be ok, but XRB holds real-return bonds, and they have a 0% expected real long-term appreciation rate, and about a 2% interest coupon. Subtracting 0.35% from that coupon (and then paying income tax at your full marginal rate!) is pretty painful. I wonder if Vanguard would reduce this MER with the proceeds securities lending.
By Patrick on Dec 11, 2009