Blog:Vanguard index fund security lending in 2013

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Blog:Vanguard index fund security lending in 2013

Post by Barry Barnitz »

Hi:

New blog post ---> Vanguard index fund security lending in 2013 | Bogleheads® Blog
In finance, securities lending involves a transfer of securities (such as stock shares or bonds) to a borrower, who gives the lender collateral (which can include shares, bonds or cash). The borrower pays the lender a fee each month for the loan and is contractually obliged to return the securities on demand.

In the U.S. the principle parties involved in security lending are the lender, the borrower, and in most instances, the agent lender.
Index mutual fund managers often use security lending income as a means of offsetting portfolio management costs. Firms usually pass along all, or a portion of security lending income to the fund portfolio.

Dimensional Fund Advisors, T. Rowe Price, and Vanguard pass along 100% of after-cost security lending income to the mutual fund/ETF investor. (Vanguard states that the average cost of the firm’s security lending program represents 5% of the program’s income; the industry average cost is 50% of income).

State Street passes along 85% of security lending income for eligible portfolios. Note that funds organized as grantor trusts (e.g. the SPDR S&P 500 and SPDR S&P Mid Cap 400 ETF) are forbidden from loaning securities. Blackrock iShares pass along 70% to 75% of security lending income to its iShares ETF investors.
The tables below provide examples of expense offsets from the 2013 fiscal year results of Vanguard index fund security lending programs.

Vanguard lends stock investments. The firm does not lend out fixed income securities.

Note that Vanguard runs its own security lending program, bypassing agent lenders. The firm elects to deal directly with borrowers, loans out illiquid stocks to reap premiums, and runs its own collateral investment program using its Market Liquidity Fund.



regards,
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Re: Blog:Vanguard index fund security lending in 2013

Post by JDDS »

Nice post. I appreciated the data in the tables.

I see the comparison of the lending income to the expenses as showing the magnitude of the program. I believe they're using this income to pay the expenses as well. This however, does not decrease the expense ratio of a fund, as that is still the operating costs vs. the assets, right?

For a fund that has all of its expenses covered by securities lending income (small cap growth), the effect is that you get a higher dividend?

This is probably straying into proprietary territory of Vanguard, but does anyone know how they determine which funds loan which securities? There's obviously multiple candidates for any given stock. My naïve thought is that factors include the amount of stock to be lent and the size of the lending fund.

What's up with those ETFs that made $1000?
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Re: Blog:Vanguard index fund security lending in 2013

Post by Tanelorn »

Even the smart money must hate small growth stocks. The SG fund covered 113% of its expenses by lending these stocks to people willing to pay for the privilege of shorting them!

I also wonder if State Street or Blackrock's 70-85% pass through rate reflects their paying an outside agent to manage their lending program, while Vanguard does it in house (which still costs something, but passing on "100% of the net" sounds nicer than "75% of the gross").
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Re: Blog:Vanguard index fund security lending in 2013

Post by Alskar »

Great article! Thanks for writing this! I've wondered how Vanguard consistently posts returns that are less than the ER below the index they track. Now I know!

I understand how it benefits Vanguard to loan out securities, but I'm not clear what the borrower gets out of this arrangement. I can't see the financial incentive to borrow an equity unless borrowing it is less expensive than buying it on the open market. Is that it?

Who gets any dividends that are issued on borrowed equities during the period the equities are on loan? Do the dividends go to Vanguard or to the borrower?
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Re: Blog:Vanguard index fund security lending in 2013

Post by dodecahedron »

Alskar wrote: I understand how it benefits Vanguard to loan out securities, but I'm not clear what the borrower gets out of this arrangement. I can't see the financial incentive to borrow an equity unless borrowing it is less expensive than buying it on the open market. Is that it?
Short sellers sell securities they don't own, so I assume Vanguard is lending to them so they have something to sell.
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Re: Blog:Vanguard index fund security lending in 2013

Post by dodecahedron »

Alskar wrote: Who gets any dividends that are issued on borrowed equities during the period the equities are on loan? Do the dividends go to Vanguard or to the borrower?
The short seller (borrower) has to compensate the owner of the security from whom he borrowed for the amount of the dividend, in that case.
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Re: Blog:Vanguard index fund security lending in 2013

Post by Barry Barnitz »

HI;

The wiki has further details regarding the mechanics off securities lending. Among the reference materials is a Vanguard white paper on the topic.

Securities lending - Bogleheads

Securities lending: Still no free lunch, Vanguard Institutional, 07/11/2011.

regards,
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Re: Blog:Vanguard index fund security lending in 2013

Post by Geologist »

Small typo in the blog post:

In the second paragraph, it should be "principal parties".
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Re: Blog:Vanguard index fund security lending in 2013

Post by LadyGeek »

Geologist wrote:Small typo in the blog post:

In the second paragraph, it should be "principal parties".
Thanks, I took care of it. (I'm a blog administrator.)

============================
A slight digression for new investors -

There's an important concept of securities lending you should be aware of. Take a look at the bottom part of the wiki's Securities lending page: Short selling stock

Replace "shorting stock" with "borrowing stock" and you'll understand why this transaction is not looked upon as favorably as "going long." It's not just a change in direction.
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Re: Blog:Vanguard index fund security lending in 2013

Post by JDDS »

Barry Barnitz wrote:HI;

The wiki has further details regarding the mechanics off securities lending. Among the reference materials is a Vanguard white paper on the topic.

Securities lending - Bogleheads

Securities lending: Still no free lunch, Vanguard Institutional, 07/11/2011.

regards,
I read the wiki earlier, but I missed the Vanguard paper. Thanks for pointing it out, it's a clear read. It confirmed several things I wondered.
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Re: Blog:Vanguard index fund security lending in 2013

Post by Alskar »

I found what I believe to be a slight disagreement between the Wiki and Vanguard's "Security lending: Still no free lunch". I'm posting it in case somebody wants to update the Wiki.

Under the second bullet item on page 3 of "Securities lending: Still no free lunch" it says, "...Because ownership passes to the borrower, cash-in-lieu-of-dividend payments--also known as manufactured dividends--are made back to the lender by the borrower."

However, the Wiki at: http://www.bogleheads.org/wiki/Securiti ... ling_stock says, "As the stock owner retains the share rights, the borrower must pass all dividends received to the owner."

These two sources disagree on which entity owns the loaned shares. In any case, they agree that the dividends go back to the Beneficial Owner.
Last edited by Alskar on Mon Jul 21, 2014 11:26 pm, edited 1 time in total.
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Re: Blog:Vanguard index fund security lending in 2013

Post by Alskar »

Here is another inconsistency:

This page (http://www.bogleheads.org/wiki/Securiti ... ling_stock) says, "Voting rights are also retained by the stock owner."

However, this page (http://www.bogleheads.org/wiki/Securities_lending) says "Borrower motivations for borrowing securities can include: ...Gaining voting rights."

I'm not complaining, just trying to add some value. I am grateful for the education!
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Re: Blog:Vanguard index fund security lending in 2013

Post by ASUGrad »

I see the comparison of the lending income to the expenses as showing the magnitude of the program. I believe they're using this income to pay the expenses as well. This however, does not decrease the expense ratio of a fund, as that is still the operating costs vs. the assets, right?

For a fund that has all of its expenses covered by securities lending income (small cap growth), the effect is that you get a higher dividend?
Well they wouldn't want to use the income to lower fund expenses on paper because what happens if people stop borrowing as much? Then Vanguard has to show expenses going from -0.01% to 0.09% for the small cap growth which would confuse the crap out of people on two different levels(why negative? and why did it go up?). Its better to just leave it as 0.09% and then add the 'income' to the fund returns. Notice that the small cap growth admiral fund normally outperforms its index, and the investor share underperforms its index by a LOT less than its 0.24% ER. The securities lending income is clearly offsetting it by quite a bit.
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Re: Blog:Vanguard index fund security lending in 2013

Post by Barry Barnitz »

ASUGrad wrote:
I see the comparison of the lending income to the expenses as showing the magnitude of the program. I believe they're using this income to pay the expenses as well. This however, does not decrease the expense ratio of a fund, as that is still the operating costs vs. the assets, right?

For a fund that has all of its expenses covered by securities lending income (small cap growth), the effect is that you get a higher dividend?
Well they wouldn't want to use the income to lower fund expenses on paper because what happens if people stop borrowing as much? Then Vanguard has to show expenses going from -0.01% to 0.09% for the small cap growth which would confuse the crap out of people on two different levels(why negative? and why did it go up?). Its better to just leave it as 0.09% and then add the 'income' to the fund returns. Notice that the small cap growth admiral fund normally outperforms its index, and the investor share underperforms its index by a LOT less than its 0.24% ER. The securities lending income is clearly offsetting it by quite a bit.
The following is taken from memory. Years ago Vanguard accounted for security lending income by using it as an expense reduction, thus reducing the expense ratio. The SEC mandated a change in accounting rules that required security lending income to be accounted as income (similar to received interest and dividends).

Under current tax law, prioritizing security lending income (which is not tax-preferred "qualified" dividend income) for meeting fund expenses serves to maximize the amount of qualified dividends distributed to investors.

Note: I checked the source of the voting rights link ---> Securities Lending: An Introductory Guide. The guide states that to retain voting rights, loaned shares must be recalled from the borrower. I removed the inconsistency.

regards,
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Re: Blog:Vanguard index fund security lending in 2013

Post by Alskar »

You can ignore this if I'm picking nits (I truly am NOT trying to be a pain):

The Wiki now says, "As the stock owner retains the share rights, the borrower must pass all dividends received to the owner."

However, page 3 of Vanguard's "Securities lending: Still no free lunch" says, "...Because ownership passes to the borrower, cash-in-lieu-of-dividend payments--also known as manufactured dividends--are made back to the lender by the borrower."

So who owns the shares, the beneficial owner or the borrower? Vanguard seems to be saying that the borrowed equities are held in the street name of the borrower. That means the dividends would go to the borrower who must pass them along to the lender (per the loan agreement). Similarly, the voting rights are held by the borrower (because their name is on the borrowed shares) unless the lender recalls them.

If I have that right, it seems like the stock owner doesn't retain the share rights. They give up their voting rights and they only get the dividends because of a pass-through arrangement in the loan contract.
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Re: Blog:Vanguard index fund security lending in 2013

Post by dodecahedron »

Alskar, you have it right. To clarify the picture here, consider that in many (most?) cases, the borrower of the securities does not actually retain the shares he borrowed, because his whole motivation for borrowing them was to be able to short the stock by selling borrowed shares he does not own. The buyer of the borrowed stocks is a third party who does not know or care that he has bought borrowed shares from a short seller and thus the buyer expects to get all the rights and privileges associated with ownership of the stock, which means that he surely gets the dividends and voting rights. The lender of the stock thus can't expect to retain the voting privileges during the the time he has lent out the stock. The standard contract for lending securities does stipulate that the borrower must compensate the lender by paying him the amount of the dividend he would have received if he had not loaned the stock, but there is no way the borrower could enable the lender to use the voting rights because those rights are attached to shares he has already sold.
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Re: Blog:Vanguard index fund security lending in 2013

Post by larryswedroe »

Barry has it correct. From tax perspective the fund will use the income to first offset fund expenses, otherwise it's taxed as ordinary income. Once it exceeds fund expenses it is taxed that way.
That's why it's possible to see someday funds with no costs.

Few other points
Securities lending generates very low fees in easily borrowed stocks like the stocks in the S&P 500, plenty available for lending and then shorting so fees very low.
The big fees are in the extreme small growth stocks typically, which often go on what is called "special"---investors want to short them and little available to lend and fees go way up. So small blend/growth funds will generate more securities lending revenue than small value for example. Just as example I kept 2007 report by DFA on its lending revenue. As you would expect Micro fund earned 42 bp, Small earned 28 and SV earned 14. By comparison, Vanguard's small earned 14 and small value 8 (Vanguard funds not as small).

Lots of funds keep the revenue for themselves. Vanguard and DFA and some others return it all. And some return a portion.

Some of securities lending is related to foreign tax credit, where in overseas markets investors who cannot use it lend securities to those who can as tax arbitrage, typically splitting the value (you lend the security to avoid the dividend becoming income and you cannot use the tax credit related to it).

Finally, the research on stocks that are on "special" with very high lending rates is that the market can be thought of as pretty efficient there. The stocks on special have very poor returns. In fact that is another little known screen DFA uses. When a stock is on special it puts the stock on an not eligible to buy list for some period, up to 15 days typically

Hope that helpful

Larry
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