Beware of in-house security lending
Northern Finance Association conference 2019
BY Yaelle Gang | October 9, 2019
Active mutual funds that engage in securities lending through in-house lending agents should raise questions for institutional investors.
These funds may “reach for lending fees” by overweighting high-fee stocks, according to a new working paper by Travis Johnson, an assistant professor of finance, and Gregory Weitzner, a PhD student, both from the University of Texas’ McCombs School of Business.
The paper found this leads to fee-retaining active mutual funds underperforming relative to non-retaining and non-lending funds.
Securities lending is when agents rent out stocks to short-sellers for a fee.
Initially, the paper’s authors thought funds were finding ways to profit from securities lending income, but no public information was available to prove this, says Johnson.
However, the Securities Exchange Commission changed the rules — effective fiscal year 2017 — requiring mutual funds and exchange-traded funds to disclose gross lending revenues, a cost breakdown and the identity of their lending agent. Once the rules changed, the researchers were able to dig into the data, says Johnson.
They found that, where a fund is self-dealing with its lending agent, investors should worry about their portfolio choices, he notes. “They may be making a choice that is beneficial for them in the sense that it maximizes this securities lending income, but at the cost of performance in the portfolio.”
This is because evidence shows stocks with high lending fees are bad ones to buy. “They perform poorly in the future,” says Johnson. “So if we’re getting extra compensation for buying bad stocks or buying poor performers, then you end up performing poorly as a fund as well.”
Generally, high-fee stocks are small caps, which have had a lot of bad news in the past and have generated interest from short sellers. Yet, at the same time, a different group of investors are still excited about the stocks and not lending out their shares, Johnson notes. “You get in this situation where there’s a freeze in the lending market where people who want to short — it’s hard to find anyone to [lend] — the few people willing to lend now, in a supply and demand sense, can charge a very high fee.”
In the research, the authors identified “prime suspects” of funds that are “self-dealing” and “paying too much to themselves,” he adds.
Then, looking at these suspects’ portfolio choices, they found they’re making poor choices and performing worse for investors. “The most surprising thing, I think, to us, was the magnitude in the sense that it seems like these funds are costing their investors about half a per cent per year, which is a lot relative to the market, [which] goes up six or seven per cent per year, keeping around a 10th of that in order to get this extra lending income,” notes Johnson.
He says pension funds should be asking questions about securities lending operations. “In particular, who the lending agent is, what the lending agent is being paid and whether that’s affecting the portfolio that the asset managers are choosing.”
It’s a good example of how there’s no free lunch, adds Johnson, noting securities lending is one way funds can offer cheap or free asset management. “But there may be a hidden cost to free, or cheap, and that hidden cost is a misalignment in portfolio decisions where they may be making portfolio choices with a different objective than you would want as an investor.”