Understanding Security Lending

Mutual fund and ETF products are often touted in the financial media as efficient vehicles for achieving portfolio diversification. However, most investors are unaware of the additional benefit that is derived from security lending programs. But, as is true with most investment considerations, not all mutual fund families have their shareholders’ best interests in mind.

One often overlooked benefit of mutual fund and ETF ownership comes in the form of security lending, the practice of loaning a portfolio security in exchange for collateral from which the lender can earn an incremental return. The size of the security lending market is difficult to gauge given its non-transparent nature, however, Standard & Poor’s estimated $3.2 billion in revenue generated for lenders in 2011. As is true with any expected return, there are associated risks and, as you can imagine, not all fund companies’ interests are aligned with those of shareholders.

What is security lending?

Understanding the risks and the potential for adding value through security lending requires a basic knowledge of the transaction. From the perspective of a fund investor (the lender), the base case scenario has two critical components: (1) the loaning of a security to an institutional counterparty (the borrower) in exchange for cash collateral and, (2) the investment of the cash collateral. For example, the Vanguard Total Stock Market Index (VTI) currently holds 3,284 different stocks, providing investors with exposure to the broad U.S. Stock Market. One of these stocks is Harsco Corporation (HSC), an industrial services provider headquartered in Camp Hill, Pennsylvania. Vanguard can elect to enter a transaction (on behalf of all shareholders) in which it lends shares of HSC from its portfolio to a borrower seeking ownership. The borrower may be motivated to take a position in the security in order to cover a trade, add liquidity to an inventory, or sell short the position. In exchange, VTI receives cash collateral equal to between 102% and 105% of the market value of the shares lent without deviating from the investment strategy. In turn, Vanguard will reinvest the cash collateral to produce income to be distributed to the shareholders of the fund. Thus, securities lending can be an attractive source of additional revenue.

Are there risks involved?

Mutual fund and ETF investors face two principal sources of risk in security lending transactions: (1) the risk that the borrower will not be able to return the loaned security in a timely manner due to illiquidity in the market or borrower default and, (2) the risk associated with investment of the collateral. Fortunately, there are measures to mitigate these risks, namely over-collateralization of the lent security, stringent counterparty due diligence, and conservative collateral investment policies.

How do two of Truepoint’s preferred fund families measure up?

The most significant distinction between Truepoint’s recommended holdings and the rest of the fund manager universe is the percentage of security lending revenue that is ultimately distributed to shareholders. Many fund companies retain 50% or more of the income, with some even pocketing 100% of the proceeds; conversely, Vanguard and Dimensional Fund Advisors (DFA) distribute 100% of net lending revenue to fund shareholders. Additionally, Vanguard and DFA maintain a highly conservative approach to managing the collateral pool, sticking to ultra short-term, high-quality fixed income and cash instruments. Furthermore, both fund families lend securities to only a finite group of broker-dealers that have met the internal requirements of their respective security lending policies.

Security lending is an essential feature of efficient capital markets, providing liquidity for trade settlement, a method for arbitraging price discrepancies, and a tool for investors to express downside sentiment through short sales. And from an investor’s perspective, it can provide meaningful value beyond the returns generated by the investment strategy. In 2011, security lending added on average 0.08% to a Truepoint portfolio, offsetting almost a third of the weighted average expense ratio of portfolio holdings.