Securities lending boom sparks concerns on returns and voting

BOSTON (Reuters) – Securities lending by investment funds has reached its highest level in a decade, as demand for corporate bonds surged more than 30 percent over the past 18 months and short selling of Tesla(TSLA.O) and Alibaba (BABA.N) shares reaches a frenzy.

Global money managers generated nearly $6 billion in revenue during the first half of the year, loaning out stocks and bonds that often land in the hands of short-sellers such as hedge funds. It was the best performance since the start of the global financial crisis in 2008 and current volatility trends are expected to keep the upswing going, according to research firm IHS Markit.

New regulatory disclosure rules that took effect last year and fresh academic research show, however, there can be a bigger downside to securities lending than previously thought.

For one, mutual funds may overweight high-demand stocks and bonds because they generate higher fees from short-selling hedge funds. Securities lending, especially for money managers keeping a bigger portion of the fees from fund investors, could distort stock-picking behavior and hurt performance, said Travis Johnson, a professor at the University of Texas at Austin.

“(Our research) shows there is a wrong way to do this: Collect up to 30 percent of the securities lending fees and bias your investment decisions,” he said.

BlackRock Inc’s (BLK.N) securities lending revenue surged 14 percent to $338 million during the first half of the year, compared to the year-ago period. The company’s in-house securities lending agent keeps typically 20 percent to 30 percent of fees paid by borrowers. Investors in BlackRock’s largely passive funds receive the balance of the fees, though a lower percentage than at many other rival funds, U.S. regulatory filings show.

Boston-based Fidelity Investments typically keeps about 10 percent and Vanguard Group does not charge a securities lending agent fee, though administrative expenses range between 1 percent and 2 percent. Investors in Fidelity and Vanguard funds get the difference.

BlackRock’s fund investors can get more income than rivals, however, because there is more securities lending revenue to divide. “BlackRock’s returns are often the strongest in the industry,” spokeswoman Tara McDonnell said.

Joseph Chi, co-head of portfolio management at Dimensional Fund Advisors, said there is research that shows that high-demand stocks that borrowers are paying high fees on tend to underperform the market. The underperformance is generally in line with the fee paid by the borrower to the fund loaning the stock, he said. Yet if a fund company’s securities lending agent is keeping a large percentage of the revenue, what investors get may fall short of making up for the stock’s underperformance, Chi said.

Mutual funds and pension funds have long lent their securities to short-sellers to boost income for investors. In some cases, the borrowing fees can be substantial, offsetting most or all of a fund’s operating expenses.

The DFA Emerging Markets Small Cap Portfolio (DEMSX.O) generated $28.5 million in securities lending income during the six-month period that ended April 30. That was more than the fund’s $25.2 million in total expenses, giving investors a boost of nearly 0.4 percent on net assets of $7.25 billion, fund disclosures show.

MISSING VOTES

Another drawback to securities lending is how borrowed shares affect pivotal corporate elections, such as takeover proposals because asset managers who loan their shares give up their right to vote attached to those shares.

Bruce Goldfarb, president of Okapi Partners, a so-called “proxy solicitor” who rounds up votes in corporate elections, said the widespread lending of stock for short-selling often factors in those elections.

A common way this plays out, Goldfarb said, is when corporate leaders forget that an asset manager may not have as many available votes as their listed portfolio holdings suggest. Goldfarb said this probably happened in 2014 when he represented hedge fund Casablanca Capital in its successful takeover of miner Cliffs Natural Resources, now Cleveland-Cliffs Inc (CLF.N).

“We couldn’t understand why the company was so confident” it would win the contest, Goldfarb said. James Kirsch, Cliffs’ chairman at the time, declined to comment.

Fund managers can recall loaned-out shares for voting, but that option is often weighed against the extra money to be made from securities lending. Regulatory disclosures suggest asset managers often choose the money. “We believe that, generally, the likely economic value of casting most votes is less than the securities lending income,” BlackRock said in an Oct. 26 fund disclosure.

Paul Hodgson, an independent corporate governance consultant, said most fund investors would welcome the extra revenue, but some would be disappointed their manager had given up control of the votes. “I think there would be a substantial minority of clients who would say, ‘that’s not why I invested my pension’,” he said.

Reporting By Tim McLaughlin and Ross Kerber; Editing by Neal Templin and Tomasz Janowski

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