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Securities Lending – The Dark Side Of Mutual Funds

A topic that hasn’t been discussed by market observers and regulators for a while is securities lending, but it might be on the agenda again soon. iShares – the exchange-traded fund (ETF) arm of the world’s largest asset manager, BlackRock (NYSE: BLK ) – has announced that the firm will increase its engagement in securities lending and has therefore scrapped its self commitment on the percentage of securities held by the firm that can be lent to third parties. This step is rather surprising, since securities lending by ETFs was one of the main points raised by critics in the past. The reaction of the ETF industry to this announcement was for some ETF promoters to introduce a ban on securities lending, while others such as iShares introduced a maximum percentage of securities that can be lent. From my point of view, this discussion did not go far enough, since securities lending is not done only by ETFs. The vast majority of securities-lending activity is done by actively managed mutual funds, since the overall assets under management are much higher in this market segment. Is securities lending bad for the investor? Don’t get me wrong, securities lending is not bad per se , but one needs to think twice about getting a fund involved in this kind of activity, since it can have negative impacts on the fund’s performance. The first point to take into consideration is that most counterparties that lend securities use them to build short positions. If this works, the fund and therefore the shareholder of the fund will face a loss on the given position, since it is still a long position for the portfolio. This raises the question of whether securities lending is in the best interest of the fund owner/investor, since the loss might have a higher negative impact on the fund’s performance than what the lending fee adds on the positive side. Income from securities lending as a source of return The income from securities lending is the second point one needs to take into consideration, since the fund does not benefit from the full lending fee. Even though the fund and therefore the investor bear the full risk of the default of a borrower, the lending fee is normally shared between the investor and the fund promoter. Securities-lending activities offer a free lunch to fund promoters, since they get return without bearing any risk. This stream of risk-free cash might be one of the reasons iShares has scrapped its restrictions on securities lending. iShares has lowered dramatically the management fees for some of its ETFs on major market indices to compete with Vanguard in Europe. This means the revenue of iShares and therefore the revenue of the asset manager, BlackRock, might have decreased, and they may want to regain profit by increasing their securities-lending activity – one of the easiest ways to achieve this goal. I think it would be much fairer if the fund promoter got a fixed handling fee for its involvement in the securities-lending activities of the fund instead of a large percentage of the overall income generated by these activities. Again, the fund promoter does not bear any risk and should therefore receive only a small part of the income. An investor should carefully read the annual report of the fund, especially where it is stated how much revenue the fund has made from securities lending and how much of this revenue has been paid to the fund promoter. Collateral as an additional source of risk One may argue that the investor bears no risk from securities-lending activities, since normally all transactions are secured by collateral. That is right, and in most cases these transactions are even over-collateralized. But, since the current regulations on which securities can be used as collateral are rather weak, some market participants may use the collateral to offload toxic or illiquid paper from their balance sheet. If a bank wants to reduce risk on its balance sheet, it may borrow some government bonds from a fund and return unrated or other risky assets as collateral to the lender. This may not look like a serious issue for fund shareholders at first sight, since they won’t own this paper as long as the borrower does not default. But if there is a default, it would be questionable whether all the securities within the collateral are liquid and at what price they can be sold to pay the dues. In this case even an over-collateralization might not protect the investor from a loss in the net asset value of the fund. Increased market efficiency-the bright side of securities lending Even though securities lending seems to be a questionable practice from a shareholder’s point of view, it has some positive effects on the markets. One of these positive effects is increased liquidity in the markets, since all transactions done by the lender increase the liquidity in the underlying security and therefore in the overall market. But it is not only liquidity that makes a market efficient. In addition, the different market participants need to have the ability to “bet” against a security, if the valuation seems to be too high. In this regard, securities lending does help increase the efficiency of markets, since short selling has the effect of bringing down the price of a security. The strategy of a short seller is to search for securities that seem to be overvalued and try to bring the price of the security to a lower level, i.e., a price that is closer to the real value of the security. Monitoring securities-lending activities-a call for investors and regulators From my point of view, the idea of securities lending is not bad at all. But to follow this strategy with securities held in a mutual fund, which is owned by long-term retail investors who can’t evaluate the risk of this kind of activity is a bad idea, especially when the revenue from securities lending is shared between the fund promoter and the investor. Again, I don’t think securities lending is necessarily a bad thing, but investors in a fund should know about these activities before they buy the product. Regulators should force fund promoters to disclose in the key investor information document (KIID) whether they are doing securities lending or not and how the revenues are shared. In addition, the regulator should set clear guidelines on the quality of the securities used as collateral, since this could decrease the level of risk for the investor. It would be helpful for the investor if all funds and not only ETFs would disclose on their website the collateral they accept for the securities they lend out. This would help fund selectors and investors make educated decisions on the risk they might have from securities lending within the fund and would lead to more educated decisions in the fund selection process. Even though some promoters may find this level of transparency hard to achieve, investors should claim a need for this information; they own the assets of the fund and the promoter is the fiduciary who should act in the best interests of the investor. On the other hand, it might be possible that regulators should ban all securities-lending activities from retail mutual funds, if fund promoters are not willing to disclose all the information needed by investors to make a proper evaluation of a mutual fund. After the financial crisis of 2008 investors have become very cautious on the use of derivatives, securities lending, and the involved collateral of mutual funds. I could imagine that it might be a competitive advantage for an asset manager to not be employing any of these techniques when the next crisis hits the market. The views expressed are the views of the author, not necessarily those of Thomson Reuters.

The Problem With Leverage In A Portfolio

Barry Ritholtz has a new article on Bloomberg discussing San Diego County’s firing of a risk parity firm that used to manage part of its pension. Risk parity strategies often engage in using leverage. Cliff Asness, who runs AQR, a firm implementing risk parity approaches (among others), hated Barry’s piece and called it “facile” “innuendo”. He then referred to a piece explaining why he likes leverage in a portfolio at times. So, who’s right? Leverage is a bit like steroids. Steroids are neither good nor bad. They tend to magnify the effect of something and that can be good or bad depending on how it’s used. If you use steroids in specific targeted ways they can be an effective medical treatment. Likewise, if you abuse them they can be a destructive and unnecessary supplement.¹ Leverage is essentially the same thing. It will magnify the effect of a portfolio’s outcomes. There are very reckless ways to do this and very safe ways to use leverage. But one thing is almost always undeniable – leverage will cost you. And that’s the kicker. Borrowing money you don’t have is essentially a form of renting. And renters charge fees. The cost of leverage in a portfolio typically depends on the fee that brokers charge. This is usually a spread over LIBOR. This allows clients to fund their long positions and the broker pays some spread below LIBOR for cash deposited by the clients as collateral for short positions. The cost of the leverage will vary depending on who the borrower is.² The inherent difficulty in using leverage is that the fund manager is essentially passing on another cost to the end investor. That is, leverage reduces the real, real return of a portfolio by the cost of the leverage. In the aggregate we know that all managers are generating the market return minus their costs (taxes, fees, etc.) so if everyone started using leverage then our returns would be reduced by the cost of the leverage. And that’s the difficulty of using leverage in a portfolio. I like the concept of Risk Parity, but it’s hard to justify owning a lot of such a strategy simply because it’s an inherently expensive strategy to manage. And in a world that is likely to be a low return world that is potentially just adding another hurdle we don’t need. ¹ – I am not a doctor and I don’t even play one on TV. ² – This cost will vary on how the leverage is implemented. The cost of many risk parity approaches results from trading in more expensive underlying instruments such as reverse repurchase agreements, futures and swap transactions or certain other derivative instruments. In addition, many institutions are able to obtain this leverage inexpensively, but ultimately pass on the convenience of this exposure to clients in higher management fees. Share this article with a colleague

What Is Liquidity? (Part VIII)

Here are some simple propositions on liquidity: Liquidity is positively influenced by the quality of an asset. Liquidity is positively influenced by the simplicity of an asset. Liquidity is negatively influenced by the price momentum of an asset. Liquidity is negatively influenced by the level of fear (or overall market price volatility). Liquidity is negatively influenced by the length of an asset’s cash flow stream. Liquidity is negatively influenced by concentration of the holders of an asset. Liquidity is negatively influenced by the length of the time horizon of the holders of an asset. Liquidity is positively influenced by the amount of information available about an asset, but negatively affected by changes in the information about an asset. Liquidity is negatively influenced by the level of indebtedness of owners and potential buyers of an asset Liquidity is negatively influenced by similarity of trading strategies of owners and potential buyers of an asset. Presently, we have a lot of commentary about how the bond market is supposedly illiquid. One particular example is the so-called flash crash in the Treasury market that took place on October 15th, 2014 . Question: does a moment of illiquidity imply that the US Treasury market is somehow illiquid? My answer is no. Treasuries are high quality assets that are simple. So why did the market become illiquid for a few minutes? One reason is that the base of holders and buyers is more concentrated. Part of this is the Fed holding large amounts of virtually every issue of US Treasury debt from their QE strategy. Another part is increasing concentration on the buyside. Concentration among banks, asset managers, and insurance companies has risen over the last decade. Exchange-traded products have further added to concentration. Other factors include that 10-year Treasuries are long assets. The option of holding to maturity means you will have to wait longer than most can wait, and most institutional investors don’t even have an average 10-year holding period. Also, presumably, at least for a short period of time, investors had similar strategies for trading 10-year Treasuries. So, when the market had a large influx of buyers, aided by computer algorithms, the prices of the bonds rose rapidly. When prices do move rapidly, those that make their money off of brokering trades take some quick losses, and back away. They may still technically be willing to buy or sell, but the transaction sizes drop and the bid/ask spread widens. This is true regardless of the market that is panicking. It takes a while for market players to catch up with a fast market. Who wants to catch a falling (or rising) knife? Given the interconnectedness of many fixed income markets who could be certain who was driving the move, and when the buyers would be sated? For the crisis to end, real money sellers had to show up and sell 10-year Treasuries, and sit on cash. Stuff the buyers full until they can’t bear to buy any more. The real money sellers had to have a longer time horizon, and say, “We know that over the next 10 years, we will be easily able to beat a sub-2% return, and we can live with the mark-to-market risk.” So, though they sold, they were likely expressing a long-term view that interest rates have some logical minimum level. Once the market started moving the other way, it moved back quickly. If anything, traders learning there was no significant new information were willing to sell all the way to levels near the market opening levels. Post-crisis, things returned to “normal.” I wouldn’t make all that much out of this incident. Complex markets can occasionally burp. That is another aspect of a normal market, because it teaches investors not to be complacent. Don’t leave the computer untended. Don’t use market orders, particularly on large trades. Be sure you will be happy getting executed on your limit order, even if the market blows far past that. Graspy regulators and politicians see incidents like this as an opportunity for more regulations. That’s not needed. It wasn’t needed in October 1987, nor in May 2009. It is not needed now. Losses from errors are a great teacher. I’ve suffered my own losses on misplaced market orders and learned from them. Instability in markets is a good thing, even if a lot of price movement is just due to “noise traders.” As for the Treasury market – the yield on the securities will always serve as an aid to mean reversion, and if there is no fundamental change, it will happen quickly. There was no liquidity problem on October 15th. There was a problem of a few players mistrading a fast market with no significant news. By its nature, for a brief amount of time, that will look illiquid. But it is proper for those conditions, and gave way to a normal market, with normal liquidity rapidly. That’s market resilience in the face of some foolish market players. That the foolish players took losses was a good thing. Fundamentals always take over, and businesslike investors profit then. What could be better? One final aside: other articles in this irregular series can be found here .