September 11, 2017

Monday Morning Memo: Should the Rules on Securities Lending in UCITS Funds Be Revised?

by Detlef Glow

A topic I hear discussed frequently is securities lending as a modern management technique to increase returns of mutual funds and ETFs. Even though I see some benefits for the markets in general and investors in specific, I think that securities lending is—under the current regulation regime—a management technique that should not be used for funds sold to retail investors. This opinion may lead to some raised eyebrows from industry participants who don’t see a risk for investors coming from securities lending. They would say that lending transactions are normally over-collateralized, and in many cases the possible shortfall risk is covered by borrower default indemnity agreements or other guarantees.

Nevertheless, securities lending can be approached from different angles, and I became quite concerned when I read that the International Securities Lending Association (ISLA) tried to convince European policymakers to ease the rules for securities lending (Ignites Europe, September 1, 2017–Industry calls for changes in UCITS stock lending rules). It should be clear to everyone that the financial industry is not a nonprofit industry. If a lobby group approaches a regulator to ease regulations, it is mainly to increase the group’s revenues. Though the group may say that securities lending enhances the performance of the respective funds and therefore the returns of the investors, securities lending may also have negative impacts on the performance of a fund. Since the borrower will sell the security to profit from a possible loss caused by this transaction, that loss may impact the net asset value of the fund and may offset the additional income from the securities lending transaction, especially if this income is shared between the lending agent, the fund management company, and the investor.

Don’t get me wrong here; I am not against securities lending in general. As mentioned above, I understand the benefits coming from securities lending and the related short transactions for the efficiency of the securities market. But from my point of view investors should be clearly informed about the respective securities lending policies of a fund before they buy it. It is not enough to state in legal language in the fund prospectus that the respective fund is involved in securities lending. I strongly believe that if investors have the opportunity to choose between a share class with or without securities lending from a given fund, a significant number of investors would rather buy the share class not involved in securities lending.

I see it as a smart move for regulators to change the legislation framework for the direction of the industry, but at the same time they need to force the industry to offer an additional share class without any exposure to securities lending for every share class involved in securities lending. I know this sounds a bit odd, since it would increase the number of share classes massively, but it would benefit investors because they would have a choice and would no longer be exposed to management techniques they don’t like. They have to accept these techniques at the moment if the fund they like is involved in these practices. Even though this may sound like wishful thinking, some fund promoters such as ComStage–the ETF arm of the German Commerzbank—do offer share classes that are not involved in securities lending for some of their ETFs.

The views expressed are the views of the author, not necessarily those of Thomson Reuters.

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