Lending equities is an important source of income for investment advisors. What influences the decision to lend? How does it affect the performance of funds?
Researcher: Melissa Prado
The dramatic growth in the percentage of mutual funds lending equities suggests that lending is an increasingly important source of income for investment advisors. There are several determinants that influence this decision in the first place and ultimately the performance of mutual funds. In the working paper: “Equity Lending, Investment Restrictions and Fund Performance”, Richard B. Evans (Darden School of Business), Melissa Prado (Nova SBE) and Miguel Ferreira (Nova SBE) contribute to this understanding.
Lending or selling?
A securities lending program offers a unique opportunity for mutual funds to generate additional income. By lending the securities in their portfolio, funds earn both interest and appreciation on the collateral of loaned securities. Nonetheless, shortselling/borrowing demand for a stock is a strong signal of future underperformance. While many investors cannot profit from this short-selling demand signal due to arbitrage limits, in particular the difficulty in borrowing the stock, fund managers who are long the stock of interest, would only have to sell their shares in order to benefit. Thus, it is an empirical question whether the income generated from security lending outweighs the potential improvement in a fund’s performance if the manager sells the stock in response to a short-selling demand signal.
Understanding the determinants of fund performance
Using a sample of 1,924 active and 146 passive equity funds over the 1996–2008 period, the researchers examine security lending practices and their impact on mutual fund performance. They find that actively managed equity funds that lend securities underperform otherwise similar funds that do not lend.
This paper contributes to the understanding of the determinants of mutual fund performance. The authors also contribute to the understanding the economics of security lending, in particular the relation between security lending and performance and the rationale of fund families in initiating security lending programs.
Key findings show that:
• On average, equity lending has sizable adverse effects on fund performance. This result is not related to the effect of shorting supply on stock prices, but rather to how managers respond to borrowing demand for a stock by comparing the performance of managers who hold and lend the stock versus managers who sell the stock.
• Security lending can be a profitable business, but fund managers should be aware of the potential adverse effects on stock prices from securities lending.