You might have received a notice saying that that a mutual fund you hold will soon be able to engage in “securities lending.” Most investors are a little puzzled by this, as it does not happen very often. So when a fund notifies its unitholders of this change in its practices, I’m often asked whether it is a benefit to unitholders and whether it introduces and new risks to the fund.
In very simple terms, securities lending occurs when a fund lends a security to a third party for a fee. A typical loan is very short term, usually overnight, but there are times when these loans may be longer.
The legal ownership of the securities is transferred from the lender to the borrower for the duration of the loan. However, the lender still receives dividends or interest payments, and is entitled to vote in any shareholder actions. The lender also has the right to recall the security at any time.
Securities lending is very common, and is used in a number of circumstances including settlement of a trade or in the use of a short sale.
The main reason that a fund would engage in securities lending is the additional yield that it can earn for the fund. It is estimated that in a given year, the incremental return a fund can earn is in the 1 to 3 basis point range.
Risks of securities lending
But there are risks to securities lending, the biggest of which is that the borrower does not return the stock when it is due. If that happens, the fund could suffer a full loss on the securities it had lent. To protect against this, the borrower is required to post collateral, usually in the form of cash, or government securities in an amount that is equal to or greater than the value of the securities lent. The current practice is for the collateral to be worth at least 102% of the value of the securities lent. Both borrowed securities and collateral are marked to market on a daily basis, and any shortfall must be made up immediately.
Most fund companies take a number of precautions to help protect investors’ capital. They usually will deal only with reputable, well established, creditworthy banks and brokers. Examples include the big five banks, their brokerage arms, and large international dealers like JPMorgan and Barclays.
Safeguards in place
Further, most funds will have internal controls in place that limit how much of the fund can be used for securities lending. For example, with RBC Funds, the maximum is set at 50%. To further protect investors, many of the larger companies have said that they will reimburse a fund if one of the borrowers of securities fails to pay it back.
While there are some risks, I certainly wouldn’t let it keep you awake at night. All in all, it is a relatively easy way for a fund to earn another few basis points in returns for investors, without taking a ton of extra risk.
Courtesy Fundata Canada Inc. © 2015. Dave Paterson, CFA, is the Director of Research, Investment Funds for D.A. Paterson & Associates Inc. This article is not intended as personalized advice. Investments mentioned are not guaranteed and carry risk of loss.
