Discussion about securities lending and how it affects performance

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gullit18
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Discussion about securities lending and how it affects performance

Post by gullit18 » Mon Jan 02, 2017 4:56 pm

Hello,

I've seen securities lending discussed on here a few threads but I don't see a topic that has discussed it in detail. I want to take a closer look on how it affects performance and reduces the actual fees of the fund.

Let's take a look at the annual reports for the two total stock market funds for Vanguard and Fidelity, VTSAX and FSTVX. I appears VTSAX had 95,010 in securities lending on p.19 and FSTVX had 13,890,086 in securities lending on p.42. I posted the annual report links below.

Wouldn't this be a significant advantage to FSTVX to make 13 million in securities in lending while VTSAX only had 95,000 thousand? I've heard people state that Vanguard's securities in lending benefits investors more because 100% of it goes to investors and that Fidelity put 70% back in the fund but keeps the rest for themselves. If that is true, that seems to be nullified by the fact that Fidelity earns much more from securities lending.

Please let me know your thoughts on this.

https://www.vanguard.com/funds/reports/q850.pdf

https://www.actionsxchangerepository.fi ... 1%23-64%23

lack_ey
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Re: Discussion about securities lending and how it affects performance

Post by lack_ey » Mon Jan 02, 2017 5:15 pm

I'm seeing $95.0 million for Vanguard for a $401 billion fund, $13.9 million for Fidelity for a $29.5 billion fund. So 2.37 bp (0.0237%) for Vanguard and 4.72 bp (0.0472%) for Fidelity. A significant difference but not a shocking or particularly impactful one, I would say.

Do you have a source for Fidelity's securities lending split or where to find this information generally for mutual funds?

Geologist
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Re: Discussion about securities lending and how it affects performance

Post by Geologist » Mon Jan 02, 2017 5:18 pm

You've read the Vanguard annual report value for securities lending wrong (although you wrote it right in a sense in one place). In 2015, the Vanguard Total Stock Index realized $95 million from securities lending (or as you put it $95,000 thousand). So in absolute terms Vanguard realized more from securities lending than Fidelity.

Northern Flicker
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Re: Discussion about securities lending and how it affects performance

Post by Northern Flicker » Mon Jan 02, 2017 5:55 pm

Securities lending involves risk. Fidelity is taking more securities lending risk. If they aren't passing 100% of the securities lending revenue to the fund, the lending that drives the revenue they keep would create uncompensated risk for investors in the fund.

There are two ways a fund company could be contributing to risk by securities lending: 1) the stock is lent for shorting, and if the price rises sharply enough, and exceeds the floated collateral cash, the short seller may not be able to cover the loan; 2) the securities lender may invest the float aggressively and incur losses.

More aggressive securities lending, and keeping some of the revenue may be how Fidelity subsidizes the published ER while still generating profit.

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gullit18
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Re: Discussion about securities lending and how it affects performance

Post by gullit18 » Tue Jan 03, 2017 3:03 pm

Thank you for clarifying that I was reading it incorrectly, I thought that was strange.

Lack_ey I don't have any information about how each company handles the income from securities lending but I have seen it several on times on here that Vanguard puts 100% back in the fund but not Fideltiy, not sure if true or just an urban myth.

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Steelersfan
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Re: Discussion about securities lending and how it affects performance

Post by Steelersfan » Tue Jan 03, 2017 3:49 pm

jalbert wrote: There are two ways a fund company could be contributing to risk by securities lending: 1) the stock is lent for shorting, and if the price rises sharply enough, and exceeds the floated collateral cash, the short seller may not be able to cover the loan; 2) the securities lender may invest the float aggressively and incur losses.
I would combine those two into one overall risk - the chance that whoever the securities are lent to will be unable to return the lent shares at the value they were lent at.

It's not Vanguard that's doing the securities lending, it's their custodian bank, under conditions set by Vanguard, with the interest received shared by both organizations. The custodian banks have rigorous processes in place to vet who they lend the securities to so that the odds of a partial or full default are small. The process is not too different from what all lenders do, with only the largest, safest, best capitalized firms given access to borrow the securities.

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Re: Discussion about securities lending and how it affects performance

Post by Northern Flicker » Wed Jan 04, 2017 5:21 pm

Agreed, securities lending failure rates are very low, but if Fidelity is generating securities lending revenue at twice the rate of Vanguard, they are doing more lending, and thus taking more risk. 2-4 bp of benefit is not much cushion to cover any losses if a failure occurs.

And, no, it is not urban legend that Vanguard returns 100% of securities lending revenue to investors. "Social" pressure from the investment community has led ishares to increase the investor share of securities lending revenue to 75% in recent years. That it is not easy to find the percentage for Fidelity doesn't inspire confidence that it is 100%.

If Fido is generating an extra 2bp of securities lending revenue and charging 1bp less ER, is their index tracking error 3bp better?

Soft dollar arrangements with brokers is another way they can skim off from the fund without documenting it in the ER.

Ultimately, tracking error is what you should care about. In case the tone of my post suggests otherwise, I think Fidelity index funds are perfectly acceptable index fund products.

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Re: Discussion about securities lending and how it affects performance

Post by lack_ey » Wed Jan 04, 2017 5:38 pm

I would assume Fido takes a cut but I've never seen the actual figure. It generally can vary on a fund-by-fund basis too.

We know Vanguard doesn't, and I've seen that DFA and T. Rowe Price don't either. Blackrock's iShares usually takes 25-30%. As far as I've seen, Schwab ETFs take 0%. State Street's SPDR sector ETFs take 30% but some others, including the old investment trusts like SPY can't even do securities lending at all. WisdomTree takes 30%, while Invesco's PowerShares take none.


But yeah, ultimately it is reflected in tracking error so check that.

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Re: Discussion about securities lending and how it affects performance

Post by alex_686 » Wed Jan 04, 2017 5:57 pm

Jalbert, I would discount these risks.
jalbert wrote:1) the stock is lent for shorting, and if the price rises sharply enough, and exceeds the floated collateral cash, the short seller may not be able to cover the loan;


The person borrowing the shares must post collateral to cover the short position which is marked daily. Almost always the lending is done via a intermediary "prime broker" who tend to be big banks. Think Deutsche Bank or Lehman Brothers (more on that later).
jalbert wrote: 2) the securities lender may invest the float aggressively and incur losses.


If a fund lends out millions in securities it will earn a float of a few thousand dollars which is reinvested in the fund itself. So not much in the way of leverage so it can't add much to the aggressiveness of a fund.

What you want to do is look at what happened when Lehman Brothers blew up. They were sitting in the middle of a large stock lending program. No fund lost any money but it gummed up the works for weeks. It triggered tax events. etc. So more about lost opportunities than lost money.

Stock lending is low low risk.

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Steelersfan
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Re: Discussion about securities lending and how it affects performance

Post by Steelersfan » Wed Jan 04, 2017 9:28 pm

Just one more point.

Since it's the custodian bank that's dong the lending and it's the one who is determining the creditworthiness of who they lend to, it's not clear what, if any, risk the mutual fund has.

As the previous poster said, it's very low risk, as long as the custodian bank does proper due diligence who they are lending shares to and watches the value of the collateral carefully. But in a situation in 2007/2008, if things get really bad, even securities lending is not risk free.

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Re: Discussion about securities lending and how it affects performance

Post by alex_686 » Wed Jan 04, 2017 10:29 pm

Steelersfan wrote:Since it's the custodian bank that's dong the lending and it's the one who is determining the creditworthiness of who they lend to, it's not clear what, if any, risk the mutual fund has.
That is pretty clear - the fund has recourse against the the bank they lent the shares to, and only to the bank they lent the shares too. They can't go after the short sellers who borrowed shares from the bank. This is why security lending operations are concentrated with the big banks - you want somebody with a large balance sheet to stand behind the lending operation.
Steelersfan wrote:As the previous poster said, it's very low risk, as long as the custodian bank does proper due diligence who they are lending shares to and watches the value of the collateral carefully.
The prime broker does a very minimal review of who they lend shares out to. They keep an eagle eye out on the collateral. It is marked to mark daily. The SEC audits a firm's procedures on a regular basis.
Steelersfan wrote:But in a situation in 2007/2008, if things get really bad, even securities lending is not risk free.
I can only think of 2 cases in the past 20 years where securities lending has been a issue. The big one was Lehman Brothers back in 2008. It was messy but everybody was made whole in the end. The other was Stockwalk.com back in 2001. Small brokerage firm went bust on a small firm. Stock manipulation, fraud, Native American actress turn stock promoter, foreign gun runners, etc. Great story. The owners lost their shirts but their clients where made whole.

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Re: Discussion about securities lending and how it affects performance

Post by Wagnerjb » Thu Jan 05, 2017 11:26 am

alex_686 wrote: I can only think of 2 cases in the past 20 years where securities lending has been a issue. The big one was Lehman Brothers back in 2008. It was messy but everybody was made whole in the end. The other was Stockwalk.com back in 2001. Small brokerage firm went bust on a small firm. Stock manipulation, fraud, Native American actress turn stock promoter, foreign gun runners, etc. Great story. The owners lost their shirts but their clients where made whole.
A huge instance was MF Global. They were required by law to hold collateral for their clients in segregated accounts, and they misappropriated the collateral for their losses in proprietary trading in Greek bonds. In the MF Global case, everybody was made whole after quite a few years (I know, my company was one of the biggest clients, in the middle of this mess). MF Global may not be an example of securities lending but it is a very relevant example in that it involves collateral misappropriation and/or fraud.

I echo those who have stated that there is very real risk in securities lending. Don't fool yourself that you are getting a lower effective ER for nothing. Certainly, the risk is not large at all - and it may never show up. But if your Vanguard account is involved in a major securities lending fraud, it might be a while before you are made whole.

Best wishes.
Andy

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Re: Discussion about securities lending and how it affects performance

Post by Northern Flicker » Thu Jan 05, 2017 7:23 pm

An entire broker or bank doesn't have to blow up for a fund to have securities lending losses. Individual defaults don't make the news, but they can contribute to losses for the fund.

Here is an article explaining Vanguard's conservative approach, and also explaining how some players do take more risk:

https://personal.vanguard.com/pdf/icrsl.pdf

From that article:
Although not legally required to do so, both Northern Trust and Bank of New York Mellon posted after-tax charges against third-quarter 2008 earnings of roughly $150 million and $425 million, respectively, to pay back investors who lost money in their securities-lending programs (Schneyer, 2008).

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Re: Discussion about securities lending and how it affects performance

Post by Steelersfan » Thu Jan 05, 2017 10:11 pm

jalbert wrote:An entire broker or bank doesn't have to blow up for a fund to have securities lending losses. Individual defaults don't make the news, but they can contribute to losses for the fund.
It's important to remember that the losses were taken by the custody bank that held and lent the securities, not the fund they were holding the securities for, e.g. Vanguard.

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Re: Discussion about securities lending and how it affects performance

Post by Northern Flicker » Thu Jan 05, 2017 11:05 pm

By choice only. Per Vanguard's article, they could have passed the losses on to the funds and their investors.
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Re: Discussion about securities lending and how it affects performance

Post by JDDS » Fri Jan 06, 2017 1:53 am

I suppose it could effect after tax performance. While the shares are on loan, the borrower is required to repay any dividend distributions, but that is nonqualified income. So, if held in a taxable account you might get a higher tax bill because of securities lending. I believe Vanguard has avoided this in years when it has posted 100% qualified dividends by two things. The first is that they can pay themselves the expense ratio as designated from nonqualified income, e.g. securities lending revenue, REIT distributions. The second is the provision that allows a fund to treat any qualified dividend total greater than 95% as 100%.

I think some posts have mentioned in the past that some funds, including some of Vanguards, make enough from the lending to completely cover the expense ratio. (Small Cap Growth comes to mind.)

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Re: Discussion about securities lending and how it affects performance

Post by Northern Flicker » Fri Jan 06, 2017 4:10 pm

Another snippet from Vanguard's article:
In addition, although lending can take place directly between the beneficial owner and the borrower, as described earlier in our “base case,” a financial intermediary known as a lending agent—often a broker-dealer or a custodian bank—has traditionally been the provider responsible for managing the securities-lending program (Figure 3). This adds more risk to the process, primarily because the lending agent often manages the cash-collateral pool, with the net earnings split between the lending agent and the lender.
Vanguard's position is that having a custodian bank lend out the shares increases risk, not decreases it. Fund investors shoulder all of the risk, but the custodian participates in the revenue.
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Re: Discussion about securities lending and how it affects performance

Post by Steelersfan » Fri Jan 06, 2017 5:37 pm

jalbert wrote: Vanguard's position is that having a custodian bank lend out the shares increases risk, not decreases it. Fund investors shoulder all of the risk, but the custodian participates in the revenue.
Is it your opinion that Vanguard should not participate in any securities lending activities, and deny their customers the yearly financial benefit of doing it?

The securities are held by their custodian banks so Vanguard can not do it themselves.

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Re: Discussion about securities lending and how it affects performance

Post by Northern Flicker » Sat Jan 07, 2017 2:10 am

Is it your opinion that Vanguard should not participate in any securities lending activities, and deny their customers the yearly financial benefit of doing it?
Nothing I've said would suggest that. My point is that it is not a free lunch. And mutual funds that do not return 100% of the revenue to their investors are just playing the mutual fund obfuscation game, in this case, publishing an ER that looks better than your competitor, but finding ways to skim off the delta or more under the table. I think that is what ishares is doing, not sure about Fidelity.
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Re: Discussion about securities lending and how it affects performance

Post by LadyGeek » Sat Jan 07, 2017 9:22 am

This thread is now in the Investing - Theory, News & General forum (theory).
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Re: Discussion about securities lending and how it affects performance

Post by asset_chaos » Sat Jan 07, 2017 9:53 pm

gullit18 wrote:I've seen securities lending discussed on here a few threads but I don't see a topic that has discussed it in detail. I want to take a closer look on how it affects performance and reduces the actual fees of the fund.
As I'm guilty of starting one of those threads viewtopic.php?f=10&t=185828&hilit=lending, I'll repeat the data for the Vanguard small value index fund:
For small cap value index fund the income from securities lending is much more important than I'd ever considered it to be. Maybe everyone except me already knows this. The statement of operations on page 64 [from the latest annual report] says that income from securities lending in 2015 was $7.2 million, while the item for total fund expenses was $15.3 million. It's not clear if total expenses on that page includes brokerage costs, but still securities lending pays for 47% of what is labeled total fund expenses. That's a big number in Vanguard's model of at cost management. And as I think from what I've read that it's being done without introducing excess risk, securities lending appears to be an important tool in holding down the cost of index funds. Certainly a more important tool than I had previously credited it.
As far as I can tell, in this case the lending does not affect performance in that the fund closely tracks its index, while lending income covers a substantial fraction of the fund's costs. Others in that thread said lending introduces extra risk; although, it's unclear to me still what the source of that extra risk is at Vanguard. It is clear that there is extra risk if the collateral for loaned shares is put in higher risk investments, but Vanguard says they don't do that.
Regards, | | Guy

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Re: Discussion about securities lending and how it affects performance

Post by Northern Flicker » Sun Jan 08, 2017 3:49 am

Others in that thread said lending introduces extra risk; although, it's unclear to me still what the source of that extra risk is at Vanguard. It is clear that there is extra risk if the collateral for loaned shares is put in higher risk investments, but Vanguard says they don't do that.
If a shorted stock rises sharply enough, the collateral may not be enough to cover the loan. This is low risk, but not non-zero risk.

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