Fund Performance and Equity Lending:
Why Lend What You Can Sell?
Richard Evans - Darden School of Business
Miguel Ferreira - Nova School of Business and Economics
Melissa Prado - Nova School of Business and Economics
The Market for Lending/Borrowing Stock
Owner of stock
• Beneficial owner – fund investors
• Owner of record – mutual fund/custodian
Shares
Fees
Collateral (102%)
Shares
Securities Lender
Rebate
Collateral
Collateral pool
(Cash, Treasuries, MBS, uh oh…)
Income/Ret.
Borrower/
Short seller
Should Funds Lend?
• Measures of short-selling predict future underperformance
- Short interest – Asquith, Pathak, Ritter (2005)
- Specialness – Geczy, Musto, Reed (2002)
- Loan supply/demand – Cohen, Diether, Malloy (2007)
• Short-selling costs and limits to arbitrage
- Incorporating borrowing costs, some factor-related
short-selling strategies are still profitable – GMR (2002)
- Stocks with low inst. ownership (lending supply) exhibit
more extreme underperformance – APR (2005)
- Abnormal returns to short side for anomalies due
‘solely’ to special stocks - Beneish, Lee, Nichols (2014)
Why lend what you can sell?
Can Funds Benefit From Short-Selling?
• Chen, Desai, Krishnamurthy (2013) show from 1994-2009:
- MFs allowed to short increases from 24% to 63%
- Funds that actually short increases from 2.2% to 7.1%
- Those that short outperform by 1.5% annually, but…
…many funds cannot/will not short
• If funds cannot/will not short, can they benefit?
- Measures of short-selling demand signal future
underperformance so managers should sell those stocks
- Even for a long-only manager, if relative performance is
the performance metric of interest, managers can be
‘short’ relative to the benchmark
Supply vs. Demand
•
Lending income small relative to average underperformance
•
Supply-side concerns (especially after the financial crisis):
“Fidelity Worldwide Investment may be on the verge of scrapping its securities
lending programme in the latest blow to the controversial practice….The idea that we
would lend the stock that we obviously like, otherwise we would not own it, to
someone who is then going to short it does not really make much sense. It is not in the
interests of our clients to have to foster that short selling, nor is it in the interests of the
company in which we invest.”
-Dominic Ross, Chief Investment Officer, Fidelity Worldwide
•
But evidence suggests that demand-side dominates – for example,
Kaplan, Moskowitz, and Sensoy (2012):
- Run experiment for an anonymous money manager in 2008-2009
- Returns to stocks made available to lend don’t differ from stocks
that were not lent
Research Questions
• How prevalent is security lending among mutual funds?
• Are investors better off purchasing funds that lend securities or
prohibit lending?
- Does the income generated from stock lending outweigh
potential adverse value effects of holding stocks with shortselling demand?
- Why lend what you can sell?
• If not for fund performance, why do fund families’ initiate
security lending programs?
The Market for Lending/Borrowing Stock
Sources of equity lending demand:
• Primary – short-selling
• Secondary – voting (Aggarwal, Saffi, Sturgess)
• Secondary – tax avoidance (Christoffersen+GMR)
Sources of equity lending supply (top 3 in 2012):
• US Mutual funds (22%)
• Insurance companies (12%)
• US Pension funds (11%)
• Unidentified/other (36%)
Data
• N-SAR filings on security lending practices:
• Merge N-SAR data with CRSP mutual funds data
• Sample: 2,070 open-end domestic equity funds
- Dates: 1996 to 2008
- Exclude international, bond, sector, close-end funds
- 1,924 active funds and 146 index funds
Securities Lending Practices
Securities Lending by Index Funds
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Lending Allowed
Actually Lent
Securities Lending Practices (2)
Securities Lending by Active Funds
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Lending Allowed
Actually Lent
Security Lending Practices (3)
Security Lending and Fund Performance
• Active funds that lend underperform (4-factor alpha)
• Multivariate regression
- Control for expenses, fund and family size, flows, turnover,
distribution channel, past performance, style, time, fund FE
- Cluster standard errors by fund
- Underperform between 0.45% and 0.82% annually
• Propensity Score Matching
- Treated sample: Funds that lend securities
- Control sample: Fund that don’t lend securities but are
allowed to with closest propensity score at the same date
(nearest-neighbor)
- Active funds that lend underperform by 0.46% annually
- Index funds that lend outperform by 0.20% annually
What We Have Learned So Far
• Willingness to lend shares by U.S. mutual funds has increased
• Cross-sectional differences among funds that are allowed to
engage in security lending and funds that are not allowed
• Actively managed funds that lend securities underperform
funds that do not lend securities
• Why lend what you can sell?
Propensity Score Matching Probit
Active Funds
Coef
t-Stat
Fund Utilization
Expense Ratio
ln(TNA)
Net Flow
0.021 **
-0.084
0.103 ***
2.55
-0.93
5.35
-0.014 *** -4.93
Turnover
0.001
0.04
ln(Family TNA)
0.065 ***
3.80
Investment Objective Herfindahl
-0.424 *** -3.20
Average Family Performance Rank -0.035 **
Index Funds in Family
0.220
-2.49
0.66
0.598 *
1.81
Broker Funds in Family
-0.822 **
-2.40
Average Family Expense Ratio
-7.810
-0.74
Average Family Active Share
Style Fixed Effects
Observations
-1.758 *** -5.93
Yes
92,820
Sudadvised Funds in Family
Why Do Families Initiate Equity Lending Programs?
• Family goal: maximize assets under management
- Family sets investment restrictions to diversify fund offerings
across investment objectives
- Require managers not to deviate from their style, regardless style
is in favor by investors
• Predictions:
- Underperformance more pronounced in funds with more
investment restrictions
- Managers of funds that lend equities are less sensitive to short
selling demand signal
- Higher likelihood that family “recaptures” outflows to other
funds in family
Anecdotal Evidence
Kevin Parke, Chief Investment Officer of Massachusetts
Financial Services:
“…some types of stocks are always out of favor and I want our managers to
stay with those stocks, picking the best of the worst. When they come back
into favor, MFS will be prepared for the inevitable surge in inflows. So I will
continue to pay a manager well who is doing a good job in an out-of-favor
fund. But they must stick to picking the best stocks in their respective
category. I’m not going to reward a value manager who beat her index by
including tech stocks (when tech stocks were hot) in her portfolio. That is
cheating. We need to build an excellent track record and expertise in each of
our asset classes over the long run.”
Hall, B., Lim, J., 2004, Massachusetts Financial Services, Harvard Business School Case 902-132.
Investment Restrictions
• Mutual funds have various investment restrictions, outcome of
optimal contracting equilibrium (Almazan, Brown, Carlson,
and Chapman (2004))
• Calculate yearly fund-level index of investment restrictions
using N-SAR forms (question 70N)
- Leverage: borrowing of money, margin purchases, short
selling
- Derivatives: writing or investing in options on equities or
stock index futures
- Illiquid assets: investments in restricted securities
- Restriction index (0-1) with mean of 0.3
• In alternative, examine if options/futures traded allowed
Why Do Families Initiate Equity Lending Programs?
•
Index funds that use affiliated lending agent earn lower lending income
due to agency problems (Adams, Mansi, Nishikawa (2011))
•
In 2008 & 2009, beneficial security owners engaging in security
lending suffered losses associated with the riskiness of their security
collateral pool
MR. DAVIS: …The exhibits to [our securities lending] agreement were marvels
of simplicity. The exhibit number three, I will never forget. It purported to list the
allowable investments for collateral alone. And it said cash, securities and letters
of credit, period, the full content of that page. There was nothing about the rating
of these various instruments, there was nothing at all about the monitoring of the
instruments, there was nothing at all that described how the bank was going to
care for those instruments. So I think that even though the document itself, for a
small fund like ours, was 30 pages, the meat of it was the protection for the
lending agent, not for the beneficial owner.
Jerry Davis – Chairman, Board of Trustees - New Orleans Employees' Retirement System
SEC Securities Lending And Short Sale Roundtable (9/29/2009)
Performance, Restrictions, Affiliated Lending
(1)
(2)
(3)
Security Lending Used
0.059 -0.097*** -0.046***
(1.27)
(-2.91)
(-3.43)
Restriction Index
0.116**
(2.13)
Security Lending Used x Restriction Index
-0.187**
(-2.20)
Options-Futures Allowed
-0.035*
(-1.66)
Security Lending Used x Options-Futures Allowed
0.079*
(1.92)
Affiliated Lending Agent
0.043
(0.37)
Security Lending Used x Affiliated Lending Agent
-0.015
(-0.12)
Other Controls
Yes
Yes
Yes
Style*Time Fixed Effects
Yes
Yes
Yes
Observations
111484 111484 111484
R-squared
0.216
0.216
0.216
Number of Funds
1,701
1,701
1,701
Manager-Fund Pairs
• Reaction of fund manager to short selling demand
• Manager-fund pairs - same manager in two funds (177 cases):
- A fund is allowed to lend, but the other is prohibited
• Events: “hard-to-borrow” stocks
- Stocks in top quartile of distribution of short interest and below
median institutional ownership in a month
• Outcome: % change in number of shares held by manager around
month stock has become “hard to borrow” (using quarterly
holdings)
Manager-Fund Pairs
Position Change (%)
Position Change (%)
•
•
Security Lending
Allowed
-5.4
Security Lending
Allowed and Used
-5.8
Security Lending
Prohibited
-10.9
Security Lending
Prohibited
-14.5
Difference
5.5***
Difference
8.7***
Manager decreases position less in fund where security lending is allowed
- More so when security lending is both allowed and used
Manager is less sensitive to short-selling demand in funds with security
lending programs in place
Fund Inflows and Outflows
(1)
(2)
Fund Inflows
Family Inflows
Family Outflows
Family Security Lending Allowed
Family Security Lending Allowed x
Family Inflows
Family Security Lending Allowed x
Family Outflows
Fund Inflows (t-1)
0.629*** 0.392***
(10.60)
(3.19)
-0.009**
(-2.41)
0.505*** 0.504***
(11.48)
(11.43)
0.179*** 0.184***
(4.88)
(5.00)
Style Outflows
Controls
Time Fixed Effects
Observations
R-squared
-0.011***
(-3.64)
0.355***
(3.56)
0.263*
(1.80)
0.579*** 0.578***
(20.96) (20.96)
Fund Outflows (t-1)
Style Inflows
(3)
(4)
Fund Outflows
0.523*** 0.212***
(9.34)
(2.84)
0.169** 0.178***
(2.52)
(2.63)
Yes
Yes
98,941
0.446
Yes
Yes
98,941
0.447
Yes
Yes
98,941
0.353
Yes
Yes
98,941
0.354
• Positive correlation
between fund inflows
(outflows) and family
outflows (inflows)
• Relation is stronger
when family has
security lending
program
Conclusion
• Active funds lend securities underperform otherwise similar
funds that do not lend securities
• Why?
- Manager cannot act on short-selling demand due to
investment restrictions set by family to diversify its fund
offerings across styles
- Security lending at least generates some income that
minimizes effect of short selling demand
Contributions
• Contributes to the understanding of the consequences of security
lending for mutual funds
- There may be important detrimental effects on value of
portfolio holdings due to security lending
• Shed light on the issue of why fund families initiate
security lending programs
• Family-level profit maximization concerns dominate fundlevel performance concerns
Robustness
Security Lending Income
Security Lending Collateral
Controls
Style Fixed Effect
Observations
R-squared
(1)
-0.630***
(-2.79)
Yes
Yes
67,254
0.003
(2)
(3)
-1.102***
(-3.54)
0.071 0.400***
(0.73)
(3.36)
Yes
Yes
Yes
Yes
74,587
63,562
0.003
0.003
• Use lending income and collateral (% of TNA), rather than
“Security Lending Used” dummy
- N-CSR fillings for subsample of funds in 2002-2008
• Funds with higher lending income underperform
- Higher collateral value indicates more bargaining power as
lender and thus better lending terms