"Mutual Funds and Securities Lending"

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Taylor Larimore
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"Mutual Funds and Securities Lending"

Post by Taylor Larimore » Thu Aug 30, 2018 8:53 pm

Bogleheads:

Mutualfunds.com has an informative article about little known "Securities Lending" by mutual fund companies. The article helps explain how Fidelity is able to offer two total market index funds with zero expense ratios. Vanguard is mentioned thusly:
Mutual fund sponsor Vanguard gives 100% of its fees generated from securities lending back to its shareholders. This is one of the main reasons why Vanguard is able to offer rock-bottom expense ratios. In some cases, fees from securities lending pays for virtually all of the mutual fund’s operating costs.
For those interested, this is a link to the full article:

http://mutualfunds.com/education/mutual ... y-lending/

Best wishes
Taylor
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Re: "Mutual Funds and Securities Lending"

Post by triceratop » Thu Aug 30, 2018 8:56 pm

I don't see the relevance to Fidelity and their ZERO index fund offerings. Certainly the article doesn't even mention them. And in fact, Fidelity has promised (claimed, if you believe them) that all the returns of Securities Lending go to the fund.

See this article: http://www.investmentnews.com/article/2 ... ndex-funds
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Re: "Mutual Funds and Securities Lending"

Post by dumbmoney » Fri Aug 31, 2018 1:15 am

triceratop wrote:
Thu Aug 30, 2018 8:56 pm
And in fact, Fidelity has promised (claimed, if you believe them) that all the returns of Securities Lending go to the fund.
All the returns _after_ expenses, right? So it doesn't imply that Fidelity can't profit from lending, unless all the relevant services are outsourced.
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Re: "Mutual Funds and Securities Lending"

Post by abuss368 » Fri Aug 31, 2018 8:20 am

Thank you for sharing. The timing of this article was good as recently I was thinking about this in terms of I really had no idea what was involved.

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Re: "Mutual Funds and Securities Lending"

Post by Nate79 » Fri Aug 31, 2018 9:28 am

Someone correct me if I'm wrong but I think the quote about Vanguard is incorrect. They return 100% of the fees from securities lending AFTER EXPENSES. This is not the same thing as the quote. I recall this being discussed in depth in the previous dissection of the Fidelity Zero funds.

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Re: "Mutual Funds and Securities Lending"

Post by alex_686 » Fri Aug 31, 2018 9:36 am

dumbmoney wrote:
Fri Aug 31, 2018 1:15 am
triceratop wrote:
Thu Aug 30, 2018 8:56 pm
And in fact, Fidelity has promised (claimed, if you believe them) that all the returns of Securities Lending go to the fund.
All the returns _after_ expenses, right? So it doesn't imply that Fidelity can't profit from lending, unless all the relevant services are outsourced.
If they are using one of the big 2, State Street or Deutsche Bank, expenses would be pretty close to zero. Probably what you are left with are some accounting expenses, which scale nicely for big firms.

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Re: "Mutual Funds and Securities Lending"

Post by triceratop » Fri Aug 31, 2018 10:03 am

Nate79 wrote:
Fri Aug 31, 2018 9:28 am
Someone correct me if I'm wrong but I think the quote about Vanguard is incorrect. They return 100% of the fees from securities lending AFTER EXPENSES. This is not the same thing as the quote. I recall this being discussed in depth in the previous dissection of the Fidelity Zero funds.
Yes. Expenses were somewhat large for Fidelity funds but what was most remarkable was the size of the rebate that went back to the security borrower; the implication was Fidelity took more risk and lent less sought-after securities but it could equally be that they struck a poor deal.
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Re: "Mutual Funds and Securities Lending"

Post by Austintatious » Fri Aug 31, 2018 2:31 pm

triceratop wrote:
Thu Aug 30, 2018 8:56 pm
I don't see the relevance to Fidelity and their ZERO index fund offerings. Certainly the article doesn't even mention them. And in fact, Fidelity has promised (claimed, if you believe them) that all the returns of Securities Lending go to the fund.

See this article: http://www.investmentnews.com/article/2 ... ndex-funds
I see this text in the article you've posted:
"Fidelity is not receiving any revenue from the Fidelity ZERO Index funds for securities lending. Nor is Fidelity currently receiving any portion of the income that is generated from securities lent out."
It does not claim "that all the returns of Securities Lending go to the fund". While that may indeed be what is happening, unless I've overlooked it, there's no such claim in the article. This language stops short of that.

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Re: "Mutual Funds and Securities Lending"

Post by triceratop » Fri Aug 31, 2018 3:19 pm

Austintatious wrote:
Fri Aug 31, 2018 2:31 pm
triceratop wrote:
Thu Aug 30, 2018 8:56 pm
I don't see the relevance to Fidelity and their ZERO index fund offerings. Certainly the article doesn't even mention them. And in fact, Fidelity has promised (claimed, if you believe them) that all the returns of Securities Lending go to the fund.

See this article: http://www.investmentnews.com/article/2 ... ndex-funds
I see this text in the article you've posted:
"Fidelity is not receiving any revenue from the Fidelity ZERO Index funds for securities lending. Nor is Fidelity currently receiving any portion of the income that is generated from securities lent out."
It does not claim "that all the returns of Securities Lending go to the fund". While that may indeed be what is happening, unless I've overlooked it, there's no such claim in the article. This language stops short of that.
Returns net of expenses (lending agent fees, rebates). What is your proposed alternative scenario if not Fidelity or the fund?
"To play the stock market is to play musical chairs under the chord progression of a bid-ask spread."

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Re: "Mutual Funds and Securities Lending"

Post by nedsaid » Fri Aug 31, 2018 3:33 pm

Here is a key quote from the article:
And there are some risks.

When a fund lends the stocks, these assets are not actually part of the fund, the put-up collateral is. Typically, U.S. Treasuries or cash is used. However, in recent years everything from mortgage backed securities and derivatives to letters of credit and other exotic I.O.U.’s have become commonplace. These sorts of instruments fluctuate in price and must be marked-to-market daily. That can actually affect the net asset value of the mutual fund if they swing rapidly. An additional risk is if the mutual fund invests that money in something less than desirable to juice returns.

Secondly, if the collateral drops in value by too much, the investor borrowing the shares may be forced to add additional collateral or cover the short early. If they can’t, the mutual fund and its investors are on the hook for the damage.
I guess the question is what kind of collateral is Fidelity taking in its Zero Funds? Are they taking riskier collateral? By taking more risky collateral, are they also taking in more fees? I just wonder about the risks to us shareholders. They might be very minor or they might be more than we would expect. I just don't know.

It is getting to be that even a simple index fund is getting to be a pretty sophisticated instrument. You have portfolio lending, patient trading strategies, sampling techniques for less liquid stocks and even use of options.

Another question is if in fact that index funds are engaged in a very mild form of hedging with portfolio lending. Certainly, in a short squeeze where hedge funds had to cover their shorts, this would increase the upward movement of these stocks. It would temporarily juice the returns a tiny bit. If nothing like a short squeeze happens, the index funds still get their fees.
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Re: "Mutual Funds and Securities Lending"

Post by triceratop » Fri Aug 31, 2018 3:44 pm

nedsaid wrote:
Fri Aug 31, 2018 3:33 pm
Here is a key quote from the article:
And there are some risks.

When a fund lends the stocks, these assets are not actually part of the fund, the put-up collateral is. Typically, U.S. Treasuries or cash is used. However, in recent years everything from mortgage backed securities and derivatives to letters of credit and other exotic I.O.U.’s have become commonplace. These sorts of instruments fluctuate in price and must be marked-to-market daily. That can actually affect the net asset value of the mutual fund if they swing rapidly. An additional risk is if the mutual fund invests that money in something less than desirable to juice returns.
Source for the claim the credit quality of collateral has decreased in general, for specific funds, or at all? The article asserted it without proof.
Secondly, if the collateral drops in value by too much, the investor borrowing the shares may be forced to add additional collateral or cover the short early. If they can’t, the mutual fund and its investors are on the hook for the damage.
This is true. It's worth remembering who the index funds are lending to -- large institutional investors who are incredibly unlikely to completely blow up. That is, the index funds are doing credit analysis on their borrowers.

Another question is if in fact that index funds are engaged in a very mild form of hedging with portfolio lending. Certainly, in a short squeeze where hedge funds had to cover their shorts, this would increase the upward movement of these stocks. It would temporarily juice the returns a tiny bit. If nothing like a short squeeze happens, the index funds still get their fees.
I don't think this is true. Index funds hold long-term, I don't see how a short squeeze juices the returns of their stocks. You could equally say that by facilitating short selling by the lending of stocks, the mutual funds are hurting their performance. But really, short sellers will borrow from someone else at the margin, probably at higher cost.
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Re: "Mutual Funds and Securities Lending"

Post by UpsetRaptor » Fri Aug 31, 2018 3:47 pm

If a mutual fund has a 0 ER, like Fidelity's two funds now, does it really matter to the individual investor which of their revenue streams is covering those funds' costs? If you wanted to think of it as, say, their credit card business is funding the 0 ER funds operating costs, and ownership is just pocketing the securities lending revenue stream (just hypothetically), does that even matter? Money's fungible.

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Re: "Mutual Funds and Securities Lending"

Post by nedsaid » Fri Aug 31, 2018 3:49 pm

triceratop wrote:
Fri Aug 31, 2018 3:44 pm
nedsaid wrote:
Fri Aug 31, 2018 3:33 pm
Here is a key quote from the article:
And there are some risks.

When a fund lends the stocks, these assets are not actually part of the fund, the put-up collateral is. Typically, U.S. Treasuries or cash is used. However, in recent years everything from mortgage backed securities and derivatives to letters of credit and other exotic I.O.U.’s have become commonplace. These sorts of instruments fluctuate in price and must be marked-to-market daily. That can actually affect the net asset value of the mutual fund if they swing rapidly. An additional risk is if the mutual fund invests that money in something less than desirable to juice returns.
Source for the claim the credit quality of collateral has decreased in general, for specific funds, or at all? The article asserted it without proof.
Secondly, if the collateral drops in value by too much, the investor borrowing the shares may be forced to add additional collateral or cover the short early. If they can’t, the mutual fund and its investors are on the hook for the damage.
This is true. It's worth remembering who the index funds are lending to -- large institutional investors who are incredibly unlikely to completely blow up. That is, the index funds are doing credit analysis on their borrowers.

Another question is if in fact that index funds are engaged in a very mild form of hedging with portfolio lending. Certainly, in a short squeeze where hedge funds had to cover their shorts, this would increase the upward movement of these stocks. It would temporarily juice the returns a tiny bit. If nothing like a short squeeze happens, the index funds still get their fees.
I don't think this is true. Index funds hold long-term, I don't see how a short squeeze juices the returns of their stocks. You could equally say that by facilitating short selling by the lending of stocks, the mutual funds are deleveraging.
Well, the subject of portfolio lending is something I would like to know more about. My guess is that the risks to Index fund shareholders from the practice would be very, very small. The losses from a loss of value of collateral would probably also be very small. Don't think Vanguard and Fidelity are taking wild risks here. There is always more to these sort of things than we suspect. Something to ask about at the Bogleheads Conference this fall.
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Re: "Mutual Funds and Securities Lending"

Post by Austintatious » Fri Aug 31, 2018 4:17 pm

UpsetRaptor wrote:
Fri Aug 31, 2018 3:47 pm
If a mutual fund has a 0 ER, like Fidelity's two funds now, does it really matter to the individual investor which of their revenue streams is covering those funds' costs? If you wanted to think of it as, say, their credit card business is funding the 0 ER funds operating costs, and ownership is just pocketing the securities lending revenue stream (just hypothetically), does that even matter? Money's fungible.
If the revenue stream generated by the securities lending is greater than that necessary to pay expenses, it absolutely matters that the management and/or its agents are pocketing the excess, especially so if there are similar funds out there that are returning those revenues back to the funds shareholders. It's the shareholders, after all, who are bearing the risks of that gambling with their assets. And the more management accepts diminishing qualities of collateral, the greater risk is imposed on the shareholders and the more it matters.

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Re: "Mutual Funds and Securities Lending"

Post by triceratop » Fri Aug 31, 2018 4:26 pm

Austintatious wrote:
Fri Aug 31, 2018 4:17 pm
UpsetRaptor wrote:
Fri Aug 31, 2018 3:47 pm
If a mutual fund has a 0 ER, like Fidelity's two funds now, does it really matter to the individual investor which of their revenue streams is covering those funds' costs? If you wanted to think of it as, say, their credit card business is funding the 0 ER funds operating costs, and ownership is just pocketing the securities lending revenue stream (just hypothetically), does that even matter? Money's fungible.
If the revenue stream generated by the securities lending is greater than that necessary to pay expenses, it absolutely matters that the management and/or its agents are pocketing the excess, especially so if there are similar funds out there that are returning those revenues back to the funds shareholders. It's the shareholders, after all, who are bearing the risks of that gambling with their assets. And the more management accepts diminishing qualities of collateral, the greater risk is imposed on the shareholders and the more it matters.
But Fidelity is stating that none of the revenue goes back to Fidelity, so I do not quite understand why you say "it absolutely matters that the management and/or its agents are pocketing the excess" as a matter of fact, when it is not true. As for agents costs, even Vanguard has those.
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Re: "Mutual Funds and Securities Lending"

Post by Austintatious » Fri Aug 31, 2018 4:51 pm

triceratop wrote:
Fri Aug 31, 2018 3:19 pm
Austintatious wrote:
Fri Aug 31, 2018 2:31 pm
triceratop wrote:
Thu Aug 30, 2018 8:56 pm
I don't see the relevance to Fidelity and their ZERO index fund offerings. Certainly the article doesn't even mention them. And in fact, Fidelity has promised (claimed, if you believe them) that all the returns of Securities Lending go to the fund.

See this article: http://www.investmentnews.com/article/2 ... ndex-funds
I see this text in the article you've posted:
"Fidelity is not receiving any revenue from the Fidelity ZERO Index funds for securities lending. Nor is Fidelity currently receiving any portion of the income that is generated from securities lent out."
It does not claim "that all the returns of Securities Lending go to the fund". While that may indeed be what is happening, unless I've overlooked it, there's no such claim in the article. This language stops short of that.
Returns net of expenses (lending agent fees, rebates). What is your proposed alternative scenario if not Fidelity or the fund?
You said that Fidelity claims that all the returns generated by lending securities from these zero er funds came back to the funds. You cited an article presumably reflecting that claim by Fidelity. And that caught my attention because I would view that as somewhat reassuring considering my belief that the lending of securities by mutual funds is fraught with the potential for abuse. So I read the article and discovered that there is no such statement in there. Again, the language used by the Fidelity rep:
"Fidelity is not receiving any revenue from the Fidelity ZERO Index funds for securities lending. Nor is Fidelity currently receiving any portion of the income that is generated from securities lent out."
Now, they may well be running the most cost-efficient securities lending program on the planet and returning to the shareholders every possible cent generated therefrom, but it doesn't say that or anything like it in that article, that I can see.

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Re: "Mutual Funds and Securities Lending"

Post by UpsetRaptor » Fri Aug 31, 2018 5:02 pm

Austintatious wrote:
Fri Aug 31, 2018 4:17 pm
UpsetRaptor wrote:
Fri Aug 31, 2018 3:47 pm
If a mutual fund has a 0 ER, like Fidelity's two funds now, does it really matter to the individual investor which of their revenue streams is covering those funds' costs? If you wanted to think of it as, say, their credit card business is funding the 0 ER funds operating costs, and ownership is just pocketing the securities lending revenue stream (just hypothetically), does that even matter? Money's fungible.
If the revenue stream generated by the securities lending is greater than that necessary to pay expenses, it absolutely matters that the management and/or its agents are pocketing the excess, especially so if there are similar funds out there that are returning those revenues back to the funds shareholders. It's the shareholders, after all, who are bearing the risks of that gambling with their assets. And the more management accepts diminishing qualities of collateral, the greater risk is imposed on the shareholders and the more it matters.
I'm talking about funds with a 0 ER. So any costs to run, the company is eating. If the cost is 0 and stays 0, why would the investor care about which other revenue streams get the broker to 0, or the risks involved on what they may be doing with those revenue streams? If someone gives you a free beer, why should you care if they took risk to generate the money for them to buy the beer? Really, why would you care about the cost of the beer to them at all?

In reality, a broker like Fidelity has many revenue streams that they operate from, and if they decide to run a mutual fund with an ER of 0, trying to overanalyze any one of those revenue streams in isolation, in regards to the 0 ER fund, is pretty futile.

As long as the ER stays 0.

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Re: "Mutual Funds and Securities Lending"

Post by triceratop » Fri Aug 31, 2018 5:06 pm

Austintatious wrote:
Fri Aug 31, 2018 4:51 pm
triceratop wrote:
Fri Aug 31, 2018 3:19 pm
Austintatious wrote:
Fri Aug 31, 2018 2:31 pm
triceratop wrote:
Thu Aug 30, 2018 8:56 pm
I don't see the relevance to Fidelity and their ZERO index fund offerings. Certainly the article doesn't even mention them. And in fact, Fidelity has promised (claimed, if you believe them) that all the returns of Securities Lending go to the fund.

See this article: http://www.investmentnews.com/article/2 ... ndex-funds
I see this text in the article you've posted:
"Fidelity is not receiving any revenue from the Fidelity ZERO Index funds for securities lending. Nor is Fidelity currently receiving any portion of the income that is generated from securities lent out."
It does not claim "that all the returns of Securities Lending go to the fund". While that may indeed be what is happening, unless I've overlooked it, there's no such claim in the article. This language stops short of that.
Returns net of expenses (lending agent fees, rebates). What is your proposed alternative scenario if not Fidelity or the fund?
You said that Fidelity claims that all the returns generated by lending securities from these zero er funds came back to the funds. You cited an article presumably reflecting that claim by Fidelity. And that caught my attention because I would view that as somewhat reassuring considering my belief that the lending of securities by mutual funds is fraught with the potential for abuse. So I read the article and discovered that there is no such statement in there. Again, the language used by the Fidelity rep:
"Fidelity is not receiving any revenue from the Fidelity ZERO Index funds for securities lending. Nor is Fidelity currently receiving any portion of the income that is generated from securities lent out."
Now, they may well be running the most cost-efficient securities lending program on the planet and returning to the shareholders every possible cent generated therefrom, but it doesn't say that or anything like it in that article, that I can see.
I do not follow. Are you disputing that all returns net of lending agent fees and rebates go to the fund shareholders?
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Re: "Mutual Funds and Securities Lending"

Post by triceratop » Fri Aug 31, 2018 5:10 pm

Note that it is one thing to claim that Fidelity uses securities lending revenue to cover securities lending costs. It is another to say (as Taylor implied) that the securities lending revenue covers operating costs of the fund. The reason they are different is that there would be no securities lending expenses if there were no securities lending, but there would still be operating costs for the fund.
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Re: "Mutual Funds and Securities Lending"

Post by FactualFran » Fri Aug 31, 2018 5:38 pm

UpsetRaptor wrote:
Fri Aug 31, 2018 5:02 pm
As long as the ER stays 0.
And as long as the total return is close enough to funds with a very similar investment objective.

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Re: "Mutual Funds and Securities Lending"

Post by dumbmoney » Fri Aug 31, 2018 5:53 pm

UpsetRaptor wrote:
Fri Aug 31, 2018 3:47 pm
If a mutual fund has a 0 ER, like Fidelity's two funds now, does it really matter to the individual investor which of their revenue streams is covering those funds' costs? If you wanted to think of it as, say, their credit card business is funding the 0 ER funds operating costs, and ownership is just pocketing the securities lending revenue stream (just hypothetically), does that even matter? Money's fungible.
It matters because fund investors are at risk if something goes wrong. (The fund manager is at risk indirectly because they have a valuable brand and so on, but that may not be enough to restrain reckless impulses).
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Re: "Mutual Funds and Securities Lending"

Post by dumbmoney » Fri Aug 31, 2018 6:19 pm

alex_686 wrote:
Fri Aug 31, 2018 9:36 am
dumbmoney wrote:
Fri Aug 31, 2018 1:15 am
triceratop wrote:
Thu Aug 30, 2018 8:56 pm
And in fact, Fidelity has promised (claimed, if you believe them) that all the returns of Securities Lending go to the fund.
All the returns _after_ expenses, right? So it doesn't imply that Fidelity can't profit from lending, unless all the relevant services are outsourced.
If they are using one of the big 2, State Street or Deutsche Bank, expenses would be pretty close to zero. Probably what you are left with are some accounting expenses, which scale nicely for big firms.
Doesn't somebody have to invest the collateral in a money market fund or similar? How do you do that for free?
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Re: "Mutual Funds and Securities Lending"

Post by triceratop » Fri Aug 31, 2018 6:22 pm

dumbmoney wrote:
Fri Aug 31, 2018 6:19 pm
alex_686 wrote:
Fri Aug 31, 2018 9:36 am
dumbmoney wrote:
Fri Aug 31, 2018 1:15 am
triceratop wrote:
Thu Aug 30, 2018 8:56 pm
And in fact, Fidelity has promised (claimed, if you believe them) that all the returns of Securities Lending go to the fund.
All the returns _after_ expenses, right? So it doesn't imply that Fidelity can't profit from lending, unless all the relevant services are outsourced.
If they are using one of the big 2, State Street or Deutsche Bank, expenses would be pretty close to zero. Probably what you are left with are some accounting expenses, which scale nicely for big firms.
Doesn't somebody have to invest the collateral in a money market fund or similar? How do you do that for free?
Fidelity notes that the Fidelity Securities Lending Cash Central Fund does not charge an ER.
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Re: "Mutual Funds and Securities Lending"

Post by alex_686 » Fri Aug 31, 2018 6:39 pm

dumbmoney wrote:
Fri Aug 31, 2018 6:19 pm
Doesn't somebody have to invest the collateral in a money market fund or similar? How do you do that for free?
This was my job for a few years on the mutual fund side. The cost of this thing was maybe 1/4 of a accountant hire for our mid sized fund family.

This is how it works:

The fund lends a security to a securities lending agent (such as State Street or Deutsche Bank) which lends it on to a prime broker which lends it on to a hedge fund.

The hedge fund 1) pays a fee for this privilege and 2) post collateral to the prime broker. The prime broker gets a cut of the fee, and passes fees and collateral to the securities lending agent, and the securities lending agent keeps the collateral, takes a cut from the fee, and passes the rest of the fee on to the fund. The fund never sees the collateral. Check out the annual reports - it is not on the balance sheet.

First, what happens to this fee that is paid to the fund. Part of it goes to the fund to offset expenses, part of it goes to the fund family as profit.

Second, how expensive is it to run this process? Most mutual funds hold their securities at State Street. State Street and Deutsche Bank can just plug into this. Adding a new fund family means flipping a few switches and a fractional hire of a accountant. You can kind of treat it as a utility. They do all of the heavy lifting. The fund just sits back and racks in the fees - they don't have to do much.

Vanguard is a bit different. They run their own securities lending agent.

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Re: "Mutual Funds and Securities Lending"

Post by nedsaid » Fri Aug 31, 2018 7:35 pm

alex_686 wrote:
Fri Aug 31, 2018 6:39 pm
dumbmoney wrote:
Fri Aug 31, 2018 6:19 pm
Doesn't somebody have to invest the collateral in a money market fund or similar? How do you do that for free?
This was my job for a few years on the mutual fund side. The cost of this thing was maybe 1/4 of a accountant hire for our mid sized fund family.

This is how it works:

The fund lends a security to a securities lending agent (such as State Street or Deutsche Bank) which lends it on to a prime broker which lends it on to a hedge fund.

The hedge fund 1) pays a fee for this privilege and 2) post collateral to the prime broker. The prime broker gets a cut of the fee, and passes fees and collateral to the securities lending agent, and the securities lending agent keeps the collateral, takes a cut from the fee, and passes the rest of the fee on to the fund. The fund never sees the collateral. Check out the annual reports - it is not on the balance sheet.

First, what happens to this fee that is paid to the fund. Part of it goes to the fund to offset expenses, part of it goes to the fund family as profit.

Second, how expensive is it to run this process? Most mutual funds hold their securities at State Street. State Street and Deutsche Bank can just plug into this. Adding a new fund family means flipping a few switches and a fractional hire of a accountant. You can kind of treat it as a utility. They do all of the heavy lifting. The fund just sits back and racks in the fees - they don't have to do much.

Vanguard is a bit different. They run their own securities lending agent.
Interesting. Vanguard not only has their own securities lending agent but they also have their own market neutral fund. So Vanguard could lend securities from an Index fund so that its Market Neutral fund could short it! Not sure this really happens but another way Vanguard can cut costs.

Same way if a stock goes from the Value Index into the Growth Index. Vanguard could simply transfer stocks between its own funds without having to go to a stock exchange.

Thanks Alex. Good to hear from someone who worked in the industry.
A fool and his money are good for business.

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Re: "Mutual Funds and Securities Lending"

Post by alex_686 » Fri Aug 31, 2018 8:43 pm

nedsaid wrote:
Fri Aug 31, 2018 7:35 pm
Interesting. Vanguard not only has their own securities lending agent but they also have their own market neutral fund. So Vanguard could lend securities from an Index fund so that its Market Neutral fund could short it! Not sure this really happens but another way Vanguard can cut costs.

Same way if a stock goes from the Value Index into the Growth Index. Vanguard could simply transfer stocks between its own funds without having to go to a stock exchange.

Thanks Alex. Good to hear from someone who worked in the industry.
This is getting a bit off topic, but this is not how it works. What you are suggesting is self-dealing which involve conflicts of interest. Most of these trades you are suggestion would have to be done at arm's length and are discouraged.

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nedsaid
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Re: "Mutual Funds and Securities Lending"

Post by nedsaid » Fri Aug 31, 2018 9:42 pm

alex_686 wrote:
Fri Aug 31, 2018 8:43 pm
nedsaid wrote:
Fri Aug 31, 2018 7:35 pm
Interesting. Vanguard not only has their own securities lending agent but they also have their own market neutral fund. So Vanguard could lend securities from an Index fund so that its Market Neutral fund could short it! Not sure this really happens but another way Vanguard can cut costs.

Same way if a stock goes from the Value Index into the Growth Index. Vanguard could simply transfer stocks between its own funds without having to go to a stock exchange.

Thanks Alex. Good to hear from someone who worked in the industry.
This is getting a bit off topic, but this is not how it works. What you are suggesting is self-dealing which involve conflicts of interest. Most of these trades you are suggestion would have to be done at arm's length and are discouraged.
Okay. Good point. Makes sense. Just trying to get a sense of how this actually works.
A fool and his money are good for business.

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Re: "Mutual Funds and Securities Lending"

Post by stlutz » Fri Aug 31, 2018 9:57 pm

The fund never sees the collateral. Check out the annual reports - it is not on the balance sheet.
Thanks for the informative post! However, I think I disagree with that one statement.

I am taking a look at the annual report for the Fidelity Smallcap Index fund. I actually do see the holding in the Fidelity Securities Lending Cash Central Fund, which is about 6% of the fund's assets. So, the total investment in securities for the fund adds up to 106% of net assets, with 6% in corresponding liabilities for collateral. Both also show up the fund's full balance sheet.

If I look at iShares AGG (to pick a fixed income fund that does securities lending), securities held adds up to 113% of assets, with the 13% being money market funds held with bonds lent out. As with Fidelity, I see the collateral itself on the liabilities side of the balance sheet.

And just to check one other place, I see the same type of setup on the Vanguard Smallcap index fund, with the extra assets being in the "Vanguard Market Liquidity Fund" and collateral on the liability side of the ledger.

I kind of disagree with those who say that the whole process is opaque. I would say it's hard to fully understand, but what is being done is actually disclosed quite well in funds' financial statements.

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Re: "Mutual Funds and Securities Lending"

Post by NYC_Guy » Fri Aug 31, 2018 10:02 pm

Taylor Larimore wrote:
Thu Aug 30, 2018 8:53 pm
Bogleheads:

Mutualfunds.com has an informative article about little known "Securities Lending" by mutual fund companies. The article helps explain how Fidelity is able to offer two total market index funds with zero expense ratios. Vanguard is mentioned thusly:
Mutual fund sponsor Vanguard gives 100% of its fees generated from securities lending back to its shareholders. This is one of the main reasons why Vanguard is able to offer rock-bottom expense ratios. In some cases, fees from securities lending pays for virtually all of the mutual fund’s operating costs.
For those interested, this is a link to the full article:

http://mutualfunds.com/education/mutual ... y-lending/

Best wishes
Taylor
I really wish this site was less of a Vanguard fanboi site. Schwab and Fidelity provide excellent alternatives (some might say superior) to Vanguard, particularly given that Vanguard’s tech is years behind the “for profit” providers. Just my opinion.

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Re: "Mutual Funds and Securities Lending"

Post by stlutz » Fri Aug 31, 2018 10:03 pm

Quite honestly I guess I see that the setup actually has the short-seller bearing more of the risk. The whole arrangement depends on trust between big financial institutions to make the whole thing work. Suppose that trust breaks down and the short seller doesn't return the shares. The fund gets to keep the collateral (generally cash or T-bills). If trust breaks down that badly, I want cash and T-bills, not the shares.

Where funds can take risk is in how they invest the collateral. If it's invested in T-bills, then that's super safe. Money market instruments are still very safe, but not quite as safe. But most of us are quite comfortable using money market funds for our "emergency funds" without pages and pages of debate about how risky it is. Yeah, there's some risk there, but not a whole lot.

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Re: "Mutual Funds and Securities Lending"

Post by alex_686 » Fri Aug 31, 2018 10:59 pm

stlutz wrote:
Fri Aug 31, 2018 9:57 pm
I am taking a look at the annual report for the Fidelity Smallcap Index fund. I actually do see the holding in the Fidelity Securities Lending Cash Central Fund, which is about 6% of the fund's assets. So, the total investment in securities for the fund adds up to 106% of net assets, with 6% in corresponding liabilities for collateral. Both also show up the fund's full balance sheet.
You are going to need to point me to what you are seeing.

I am looking Fidelity Small Cap Index Fund's annual report for 10/31/2017 and I am not seeing that. I am seeing about 20% of the fund in Fidelity Securities Lending Cash Central Fund, but that is not the securities that the fund has lent out. Rather it is the collateral the fund holds for its future contracts. I have not looked into iShares AGG's but I am going to guess it is something similar.

I want to note that securities lending is a completely different beast than leverage and derivatives. They show up very differently on the annual report. As a side bar, I can't think of a single time when the portfolio manager knew or even cared how much of their securities where lent out.

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Re: "Mutual Funds and Securities Lending"

Post by saver007 » Sat Sep 01, 2018 1:23 am

I think this Barrons article explain it well https://www.barrons.com/articles/etfs-h ... 1523054918

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Re: "Mutual Funds and Securities Lending"

Post by JDDS » Sat Sep 01, 2018 2:05 am

Mutual fund sponsor Vanguard gives 100% of its fees generated from securities lending back to its shareholders. This is one of the main reasons why Vanguard is able to offer rock-bottom expense ratios. In some cases, fees from securities lending pays for virtually all of the mutual fund’s operating costs.
This does not make sense to me. Since security lending revenue does not reduce an expense ratio, the revenue should have nothing to do with why Vanguard's expense ratios are what they are. The revenue reduces the tracking error for the index.

There is an insentive to keep the security lending program's fees low in the sense of better fund performance. The skeptical part of me wonders if that is enough insentive.

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