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Investment

Is your scheme in the know about securities lending?

By Tom Dines | November 19, 2015

Investment experts have laid out the steps schemes should take to minimise risks when allocating to securities lending, and warned of the potential they face for illiquidity and loss of voting rights.

Securities lending is where asset managers or schemes lend stocks or bonds in return for collateral. Managers of passive pooled funds commonly use it to generate a premium, but experts have said schemes should be aware of both the risks and benefits.

Take into account that the manager gets a part of the financial benefit but the fund takes all of the risk

Nicola Ralston, PiRho

Gavin Orpin, partner at consultancy LCP, said it was common for schemes to be involved in securities lending either directly or indirectly, although usually because managers of pooled passive funds use it to increase the takings for the funds and themselves.

He said: “It’s very common for schemes who have passive mandates to be using it… the vast majority of our clients are using it implicitly. Or for larger schemes [they] may do it on a segregated basis.

“Some managers don’t do it in certain areas, for example the UK, because they lose voting rights. The rationale for passive managers is they can use it as a way to offset the fees.”

Top tips  

PiRho's Nicola Ralston said schemes considering securities lending should consider the following points:

• Think about what you want to get out of it and do a proper assessment of whether it is worthwhile for the types of investment your fund owns. It is not a free lunch, despite the fact it is often sold as a way of minimising cash fees and being ‘efficient’.

• Negotiate the terms with the fund manager to make sure the return to the fund is maximised. Be prepared to say no if you are not convinced the benefits are sufficient.

• Make sure you understand the legal structure and your contract; ask what could happen in a worst-case scenario. Don’t be fobbed off if the answers are too general.

• Consider the impact on ability to vote, as stock that has been lent cannot be voted on.

Orpin added: “Some managers are much more transparent about giving all the benefits to the fund, some take the benefits for themselves.”

Three-step assessment

For schemes looking to make use of securities lending or to assess how their passive managers are using it, Orpin said the first step was to examine the strength of the borrower, then the strength of the collateral – which will ideally be bonds or cash – and thirdly to use insurance to bolster that collateral.

Robert McElvanney, investment consultant at Aon Hewitt, said: “If done properly it’s an appropriate risk to take; the manager has the right systems in place and has the right collateral posted to manage that risk.”

Shared reward, unequal risk

Nicola Ralston, director at investment consultancy PiRho, said that while it was common for passive managers to carry out securities lending, how the proceeds from this are subsequently distributed varied from fund to fund.

She said: “Stock lending is quite common among pooled index funds, but each fund will have its own policy, and this is one of the topics investors need to consider when [selecting] a pooled index fund or indeed any pooled fund.

“Take into account that the manager gets a part of the financial benefit but the fund takes all of the risk.”

Ralston added, however, that stock lending could have adverse effects on liquidity, but Orpin said funds generally retained the right to call the stock back if needed.

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