In an effort to enhance returns for their shareholders in an increasingly challenging environment, mutual fund boards once again are asking fund managers about participating in securities lending programs. According to The P&I/Towers Watson World 500: World's Largest Managers, nine of the top 10 asset managers currently are lending. Moreover, nearly 90% of asset managers surveyed in the Leading Asset Managers on Securities Lending and Collateral Management: A Finadium Survey said they were actively engaged in lending.
With interest rates still scraping bottom, managers of mutual funds are looking to mine alternative methods for enhancing portfolio returns. Securities lending has been one such strategy, enabling funds to not only generate incremental alpha on incremental assets but receive protections while doing so in the form of indemnification options in a risk mitigated environment.
Together with pension plans, mutual funds account for some two-thirds of the estimated $16 trillion in lending assets worldwide, according to the International Securities Lending Association. Any fund with idle assets can consider lending sub sets of their portfolios to create incremental revenue.
Generating Revenue for Fund, Shareholders
In addition to generating revenue and thus positively impacting fund performance, the fees derived from loaned portfolio assets also can be used to offset a mutual fund’s operating expenses, thereby enhancing returns as well.
To provide the fund with adequate diversification and risk mitigation, loaned assets may be distributed across as many as 25 different borrowers on average. The same holds true for lending agents; whereas funds once relied on their custodian bank to facilitate the lending process, having multiple agents gives funds more choice—including greater access to an array of asset classes, trading desks, and strategies—while also allowing them to compare the performance attributes of each agent.
Rather than reaching for yield on the reinvestment of collateral, a practice common in the pre-2008 era, a majority of funds now are focusing on extracting the intrinsic value from the assets on loan, emphasizing securities that trade “hot,” “warm,” or “special,” as well as those in high demand and/or with higher fee income. This strategy is popular since the financial crisis due to the conservative nature of the program terms and the ability to still extract value in a risk-mitigated fashion.
Additionally, term trades, which typically offer more robust returns than overnight-only or other limited-duration loans, are gaining popularity with lenders. This strategy is more suited to those with more flexible program guidelines. Faced with tougher capital requirements under Basel III, banks and broker-dealers have sought balance sheet relief in part through longer-term financing arrangements comprised of stable fixed-income assets. This demand has created a robust market for liquid term loans. According to DataLend research, loans with durations in excess of 90 days have nearly doubled since 2014, rising from 8% to some 15% of on-loan securities through June of last year.
Mutual funds that loan securities abide by a specific set of rules governing acceptable collateral, loan limits, transparency and other requirements that comply with guidelines set by the Securities and Exchange Commission. For example, loaned securities may not exceed 33% of a fund’s net asset value; further, lending activity may not deviate from the fund’s general investment guidelines and should be regularly monitored by the fund’s board to hold the fund accountable regarding lending counterparties, agent-lender costs, program performance and other integral data.
Borrowers must provide funds with collateral at the rate of 2% above the full value of the loaned asset, which subsequently may be invested in accordance with the fund’s program guidelines (total 102%). Collateral may be in the form of cash or non-cash collateral with non-cash gaining in popularity in the United States. Providers can handle either collateral set, customizing the parameters to clients’ guidelines typically found in securities lending agreements. Changes in the value of securities on loan must be marked to market on a daily basis, to ensure collateral held by the fund meets the 102% threshold.
To help maintain market stability, regulators continually have called for greater oversight into fund activities they believe could promote systemic risk, including strategies with unrestricted redemption privileges that could potentially drain fund liquidity and increase the likelihood of contagion. Thus, years after the crisis of ’08, full disclosure of securities lending remains paramount. Funds are required to notify investors in the fund’s prospectus about lending activity and include information on the types of securities on loan, nature of collateral investments, as well as income derived from lending. Additionally, funds are required to submit bi-annual financial statements that include information on lending activity for the benefit of investors and regulators; separately, funds must report on all portfolio holdings using Form N-Q prior at the start of the second and fourth quarters annually.
With its most recent set of proposals issued last year, the SEC seeks to significantly increase available information around, among other things, the securities lending activities of mutual funds. The latest initiative includes a pair of new forms: the monthly Form N-Port, requiring mutual funds to furnish data electronically—including securities lending data—to the SEC, and Form N-CEN, a census-type investment report issued once yearly. Under proposed Regulation S-X, funds would need to provide additional information on lending activities in the notes that accompany their financial statements, including average monthly on-loan values, fee income, program expenses and more.
Additionally, proposed Rule 18f-4 (which addresses fund use of derivatives), announced by the SEC last December, includes a provision determining whether the return of borrower collateral should be categorized as a commitment transaction—which in effect would eliminate the 33% lending threshold imposed on mutual funds—or, in a more restrictive move, should be included under the proposed rule’s exposure limits.
For years a standard part of the lending contract, indemnification against possible borrower default, was common. This protection has become somewhat more challenging, due to recent capital and liquidity coverage mandates. For instance, should counterparty indemnifications be included in a bank’s capital calculations, such coverage potentially could be withdrawn or offered for a fee. While a rule revision issued last November by the Basel Committee on Banking Supervision offered some relief by allowing banks to net their collateral exposures rather than calculate them based on individual securities held as collateral, fund managers nonetheless must ensure that proper indemnification safeguards are in place and are provided at no cost to the fund.
Prior to engaging in a securities lending arrangement, managers and boards must perform full due diligence into the track record of their prospective agent lender(s) and, above all, have a clear understanding of their goals to ensure the program remains aligned with the fund’s general investment principles.
Furthermore, as mutual funds increasingly view securities lending as a key investment function, they will continue to require clarity of data in order to fully understand and monitor their programs. Accordingly, customization of services, including bespoke programs tailored to funds' singular risk-return characteristics, will remain essential to fostering a secure and mutually profitable lending relationship. To help navigate an increasingly complex environment, fund boards should require timely information from their agents regarding utilization rates, counterparties, market trends, and indemnification arrangements.
Checklist for Fund Directors
Mutual fund boards considering launching and/or monitoring a securities lending program should take into account the following lending and oversight considerations:
- Indemnification against borrower default and the reinvestment of cash collateral
- Robust financial strength of provider offering indemnification
- Comprehensive operational due diligence
- Differences and benefits of using a third-party lender versus the funds’ custodian
- Customized, separately managed accounts tailored to risk profile
- Broad collateral policy, including cash and non-cash collateral programs
- Resources to monitor counterparty credit exposures and reinvestment of cash collateral credit analysis
- Global industry leaders in specific asset classes, and access to desk experts
- Contractual compliance monitoring
- Flexibility to implement program restrictions, liquidity parameters and minimum spread thresholds
- Transparent, robust and customizable reporting
George Martinez is a director and global relationship manager for the Securities Services business of BNP Paribas, where he has responsibility for managing the relationships of the group’s top-tier U.S. asset manager clientele.