At Morningstar: ETF, Mutual Fund Securities-Lending Programs Coming Under Scrutiny

With investment management fees falling sharply for index mutual funds and exchange-traded funds (ETFs), securities-lending programs can be a source of return or may benefit shareholders if the additional earnings offset fund costs.

These programs are coming under greater scrutiny considering the significant losses securities lending caused some pension funds and other investors during the 2008 global financial crisis. Many owners of indexed mutual fund and ETFs may not realize the issuers of these funds were lending out some of their securities to boost fund returns.

Yet Adam McCullough, senior analyst, index strategies, for Morningstar, said his research suggests this practice has more upside to fund holders than downside, although risks remain.

Regulatory changes to securities-lending programs have helped reduce risk, he said. McCullough spoke Wednesday at the Morningstar Investment Conference in Chicago about ETF and passive investment research. The two risks to securities lending are borrower default risk, and the cash collateral reinvestment risk, that is, the money put up to indemnify the security’s owner in case of a borrower default risk. It was the collateral reinvestment that caused most of the losses related to securities lending, he said.

The Securities and Exchange Commission (SEC) now mandates nearly all of the collateral funds be invested in US Treasuries or short-term commercial paper rated AA or higher. That’s helped to reduce the cash collateral reinvestment for mutual funds and ETFs, he said. This money is reported as net income to the fund.

Since 2017, the SEC mandated funds disclose in their statements additional information if they have a securities-lending program. In his research, McCullough looked at the top 10 fund issuers’ activity regarding securities lending, including firms like BlackRock, Vanguard, and Fidelity. Between August 2017 and October 2018, he found the issuers returned anywhere from 69.2% to 100% of the gross securities-lending revenue to shareholders.

He also found that small-cap funds saw the highest returns. “US small cap had a higher potential to make money,” he said, because it’s harder to find owners who will lend their shares.

“The average benefit to fund holder was 16 basis points. While that’s a small return, it can be meaningful enough to offset to the fund fee,” he said.

Although securities lending is coming under scrutiny, McCullough said his research shows it’s not a significant activity among fund issuers. The SEC limits securities lending to one-third of the fund’s portfolio, but the 10 issuers in his research aren’t coming close to those levels. He said between 2007 and the first half of 2018, the average percentage of a fund issuer’s portfolio on loan was under generally under 5%, except for 2008 when it was 6.5%.

There are a few reasons for that, he said. Appetite to lend out securities dried up after 2008. “There was the concern about the risk of default, but also the reputational and optics risk,” he said.

Part of that is the market conditions, he said. “There’s not much demand to short stocks in a bull market,” he said.

Ben Johnson, director global ETF research, Morningstar, also spoke about trends in smart-beta strategies. These ETFs are said to combine the best of active management in a passive vehicle by creating a rules-based active screening and applying it to an index. He said launches of smart-beta products are slowing after a slew of launches between 2015-2017. That might be a sign the product is maturing now that the marketplace is saturated with nearly 1,500 globally that hold almost $800 billion.

He said that now, issuers and groups like Morningstar itself are launching tools to facilitate adoption, which should offer investors better ways to compare these funds.