March 4, 2018

Monday Morning Memo: Follow the Money Flows—Another View of Securities Lending

by Detlef Glow

Securities lending is a widely used technique in the funds industry. Even though it is discussed more intensely in the ETF world, it is also commonly used in mutual funds. The reason for employing securities lending given by fund promoters is always the same: They claim the income from the securities-lending program is used to offset the cost of the management fees for investors, i.e., to lower the total expense ratio of the respective fund or ETF. So far, so good. But the findings of Lara Crigger in her article “Is Securities Lending Good For ETF Investors?” published on ETF.com show that fund promoters may also have other interests, since they often take a share from the securities-lending income for themselves. Securities lending may also generate additional income for the fund’s wider corporate family, since securities-lending programs are monitored and/or managed by sister companies or other affiliates of the parent company (which also charge a fee for these services). This means—in cases where there is some kind of relationship between the asset manager and the service company—the fees are additional income for the parent company.

This would not be worth mentioning if the income from securities lending was really set by the fund’s management fee; the research by Ms. Crigger shows that the benefit of the fees from securities lending is quite small and in some cases rather negligible—only around 1 basis point for the portfolio. One could argue that the research by Ms. Crigger was done only for U.S. ETFs and that the facts might be different for Europe, where the UCITS regulation allows funds to lend out more securities than the U.S. regulation does. That might be true, but I have learned from my conversations with fund and ETF promoters that the ones who aren’t involved in securities lending usually say they don’t see a real added value for investors, given that securities lending add another level of complexity to the fund. I find it rather interesting that some promoters employ securities-lending programs for their retail products, but they don’t use it for their institutional product offerings.

From my point of view, there is another point that needs to be considered: Those who borrow the security do so to generate a short position for selling it. This may lead to falling prices for the security, which means the short seller will make a profit and the overall position in the fund that lends out the securities will face a loss. Therefore, it is questionable whether securities lending generates any overall positive benefit for investors.

That said, my personal view is that investors should think twice about whether they want their funds to be involved in securities lending. An increasing number of fund buyers are at least questioning whether any value is added for them from the use of securities-lending programs.

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

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