Dirty little secrets about securities lending..

Ever thought about lending out your shares? Actually, even if you never thought about it, the chances are that it is happening..

Is Your Fund Pawning Shares at Your Expense?


Imagine you hire a real-estate agent to sublet your house. Now imagine he keeps 30% to 50% of the rent for himself. Finally, imagine that the real-estate agent makes you pay for the damages that resulted when the tenants he brought in trashed your house.

If you think that sounds unfair, get a load of how the mutual-fund industry has milked investors through the arcane practice of securities lending. Like subletting your house, securities lending is sensible and beneficial in the right hands — but can wreak havoc when it is done wrong.

Mutual funds own stocks and bonds, which usually sit idly in the portfolios for months or years. Securities lending allows a fund to make money on these stocks or bonds, without having to sell them, by lending them out and earning interest.

On stocks in high demand, borrowers fork over a fat “demand yield,” or premium. Furthermore, borrowers post cash collateral of 102 to 105 cents per dollar of securities. On top of that, the fund can earn interest by reinvesting the cash.

All told, securities lending can add at least a quarter of a percentage point to a fund’s annual returns; in small stocks or emerging markets, the bonus can exceed a full percentage point. That can make the difference between a top performer and an also-ran, particularly in the competitive world of index funds. Securities lending generated about $1.4 billion in gross income (before collateral reinvestment) at U.S. mutual funds last year, estimates Data Explorers Ltd., which researches the field.

Some fund managers, acting as lending agent, keep 50% or more of the income from securities lending; there is no legal limit. “I cannot mention names,” a leading investment consultant told me, “but there are funds doing securities lending where 100% of the revenues go back to the adviser.”

I have so far been unable to identify any of these winner-take-all companies, although I am told they are few and small. Even if it is extremely rare, this level of pilfering is a disgrace.

A few exemplary firms, like T. Rowe Price Group and Vanguard Group, rebate all securities-lending income (net of expenses) back to the funds that generated it. The total cost of Vanguard’s securities-lending program is well under 1%, says Tom Higgins, chief financial officer of the funds. That suggests that most of the 30%-to-50% toll charged by other fund managers is pure profit — in effect, money for nothing.

That isn’t the only way that management companies can rake in money by lending out your assets.

At OppenheimerFunds, cash collateral generated by securities lending may be invested in a fund run by the parent company but not registered with the Securities and Exchange Commission. There’s no way for you to get any details about what that unregistered fund is doing with your money. Oppenheimer does disclose that it charges its funds 0.08% annually to reinvest their collateral in its OFI Liquid Assets Fund. That is on top of the management fees the firm already has earned off the funds that generated the collateral in the first place. Since September 2007, I estimate, Oppenheimer has collected at least $2 million in these fees-piled-on-fees.

Oppenheimer declined to confirm that estimate but pointed out that the firm doesn’t take a cut of its funds’ securities-lending income. It added that OFI’s management fees are lower than those of its conventional money-market funds.

There is a final caveat. If your broker borrows your stock in a cash (not a margin) account, he has to ask your permission — and if anything goes wrong and he can’t return the borrowed shares, his firm is on the hook to make you whole. You have no such protection when your mutual fund or exchange-traded fund takes your own money and lends it out; incredibly, here you are the one holding the bag.

Look at Calamos Growth. This fund took $475 million in securities-lending collateral and plunked it into a supposedly safe cash account run by Bank of New York; a chunk went into securities issued by Lehman Brothers. The fund has booked $8.6 million as an unrealized loss. Unless enough blood can somehow be extracted from the Lehman corpse, it looks as if the fund investors will end up paying for the fund manager’s carelessness. A Calamos spokeswoman said no one was available to comment.

Your fund should lend out your securities, but the proceeds should go to you. And fund managers should reinvest the collateral only in absolutely safe securities. The current system, where they keep half the gains and stick you with all the risks, has got to go.