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Your Fund Manager is Lending Out Your Holdings … Should You Be Worried?

edited July 7 in Fund Discussions
Author: Derek Horstmeyer (with assistant Pamy Arora

“Unannounced to their investors, mutual-fund managers will often lend the shares they hold to short sellers who bet against particular stocks.By doing so, a fund manager can earn a little extra money (on the interest charged) and reduce the overall costs to operate the mutual fund—hopefully passing on the cost savings in the form of a lower expense ratio to the investor. But the flip side is that if the manager is lending out a good amount of the fund’s holdings, this means there is a lot of demand by other investors to bet against the exact holdings the fund manager has in the mutual fund.

“When all is said and done, if your fund manager is lending out a good amount of the underlying portfolio, is this a negative sign for future returns? The answer is a resounding yes: Active fund managers who lend out more than 1% of their holdings on average during the year underperform their fellow mutual-fund managers by an average of 0.62 percentage point a year across multiple asset classes …

“In the U.S. large-cap arena, we can see that if a fund manager is lending out shares, it isn’t a good sign for the fun fund performance. Active large-cap fund managers who lent out more than 1% of their shares averaged a return of 12.93% a year over the past 10 years. Active large-cap fund managers who lent out less than 1% of the shares averaged a return of 13.29 a year over the past 10 years. This amounts to a 0.36 percentage point difference in returns a year. … When we look at mutual fund managers who have lent out more than 2% of their portfolio on average, the results look even worse for lenders …“


WSJ July 6, 2022


Interesting Article - However, “total return” doesn’t tell the whole story. Article doesn’t address impact on fund volatility or downside performance. My (uninformed) guess is that the lenders perform better on those scores, even while generating lower overall returns.

Comments

  • beebee
    edited July 7
    I assume Index funds (which don't pick stocks) may also lend stocks that can be shorted. Behemoth index funds would have lots of share to lend at or below the 1 % level.

    Let's look at VFINX (VOO). HD is 0.97% of the fund which equates to 22 million shares of HD it could lend and which is 2% of HD shares.

    A fund like FSHOX, HD is 15% of the fund, but because of its small size it could only lend 280K shares. This equates to 0.03% of HD shares.

  • msf
    edited July 7
    The writer is a monthly columnist for the WSJ. I can find no corresponding working paper through the writer's website.

    Unannounced to their investors, mutual-fund managers will often lend the shares they hold ...
    Unannounced?
    Securities lending is a well-established practice whereby U.S. registered funds, such as mutual funds, make loans of securities to seek an incremental increase in returns for fund shareholders. This paper explains the basics of securities lending, outlines the benefits and risks for investors, and describes BlackRock’s leading approach to securities lending.
    BlackRock Securities Lending, Blackrock, January 2021
    Vanguard’s securities-lending program—which lends equities under the same philosophy and approach today as it has since well before the global financial crisis—is unique in its exclusive focus on benefiting our investors and not our bottom line. We adhere strictly to a "value-lending" philosophy, managing our counterparty credit limits and collateral pool internally through [Vanguard Fixed Income Group] FIG.
    How well did your asset manager weather the market storm? Vanguard, Sept. 2020

    Moving on:

    - Do US growth, US value, US large cap, int'l, and EM really encompass all funds? ("I looked at the full sample of actively managed equity mutual funds"). What defines these categories and where do small cap blend funds or global funds fall?

    - Is "average" unweighted, dollar weighted, or median: "The average percent lent out by active funds was 0.80%." An unweighted average would be propped up by a few funds lending over 20% of assets (see next item).

    - "we see over 2% of funds ... lending out an average of more than 20% of their underlying holdings each year—coming close to SEC guidelines." Coming close?

    From Barron's (see cite below): "Legally, exchange-traded and mutual funds can lend out as much as 50% of their unlevered securities’ portfolios to borrowers who pay them interest."

    I can offer another possible explanation for his figures. It is well known (read: find sources on your own) that high ER funds tend to be more aggressive hence more volatile, in attempting to overcome their higher costs. If these funds also are more aggressive in their lending, then one would see what he is reporting: higher rates of security lending correlating with poorer performance (due to higher ERs) and higher volatility.

    Related to covering costs is the question of how much of the lending revenue goes back into the fund vs. how much lines the pockets of the fund company? You can pretty well guess what Vanguard does. Other companies are less considerate of their investors. The writer did not attempt to correct for this factor. Nor did he attempt to control for ERs, e.g. by looking at gross rather than net returns.

    There's an excellent piece in Barron's (by some guy going by the name of @LewisBraham) discussing this and more, albeit in the context of index funds and ETFs.

    ETFs’ Hidden Source of Return—Securities Lending, Barron's April 7, 2018.

  • @hank

    >> isn’t a good sign for the fun performance.

    is this a typo in the original and preserved in your copy-paste? Or did you rekey?>
  • edited July 7
    @davidrmoran

    It’s actually a transcription error. Was unable to cut & paste the desired last few sentences. So I transcribed them reading aloud (ipad microphone function). Sloppy proof reading on my part. And I’ve corrected a couple other missteps. Thanks!

    FYI - I have the full story before me in the Kindle format. But that can’t be cut & pasted to the board. So, need to pull down as much of the story using Duck Go browser as possible. In some cases, the entire story can be accessed. More often, as in this case, just the first few paragraphs can be viewed …
  • edited July 7
    Thanks @msf for the enlightening retort to the article I linked from the WSJ. I agree that the lending ability of mutual funds has been public information for many years. The % of fund investors actually aware of it, however, may not be high.

    IMHO this article doesn’t appear to be up to the general caliber of the WSJ. I’ve gone back and updated the OP by providing the author’s name which is Dereck Horstmeyer. Horstmeyer in the piece referesences an assist from his able assistant, Pamy Arora. Apparently, Arora did some of the number crunching.

    Who is Derek Horstmeyer? “Derek Horstmeyer is an associate professor at George Mason University School of Business, specializing in exchange-traded fund (ETF) and mutual fund performance. He currently serves as Director of the new Financial Planning and Wealth Management major at George Mason and founded the first student-managed investment fund at GMU.” Source
  • In the interest of petty accuracy and little else, according to his CV Horstmeyer is a full professor (as of February), and was a co-founder of the GMU Student Managed Investment Fund.

    https://www.filesusr.com/ugd/3d3433_7004625502e5427fa5fb144f5abc2845.pdf
  • @msf, my 'petty' proofing and query had only to do with whether the quote posted as from the WSJ was actually from the WSJ, given the 'typo'; no one here is served by inexactness, of which there is enough, much less suspect or sketchy origin, and for which you have always gladly (and welcomely) played strict cop.
  • @davidrmoran - my comment was self deprecating. Nothing more. An acknowledgement that my correction, though accurate, was immaterial to the topic at hand. If anything, by stating that Horstmeyer was a full professor I was giving more weight to a piece that did not deserve it.
  • edited July 8

    my 'petty' proofing and query had only to do with whether the quote posted as from the WSJ was actually from the WSJ, given the 'typo'; no one here is served by inexactness, of which there is enough, much less suspect or sketchy origin …

    @davidrmoran,

    1) I provided you both an apology and an honest explanation of how the word “fund“ was accidentally transcribed to read “fun”. I than edited the sentence to correct the error. No need to beat a dead dog.

    2) I haven’t always supplied bylines for articles appearing in The Wall Street Journal or Barron’s, believing the stature of those publications sufficient to lend credibility. From now on I will provide a byline if available. Expect you to adhere to that requirement as well.

    3) “Full Professor - George Mason School of Business” wouldn’t normally conjure up the pejorative adjective “suspect”. Aside from this single article, do you have other evidence that Horstmeyer’s writings are unfit for sharing?

    4) None of this is meant to exclude Horstmeyer or others from honest critique and criticism. That comes with the territory.
  • I said nothing about the prof, full or other, only asked a good-faith question about copy-paste and provenance, which you explained, tyvm
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