Short Selling

"Securities lending: The last taboo?"
ISF Magazine, March 2003

Warren Buffet, the American investment guru, once remarked: “It is not necessary to do extraordinary things to get extraordinary results.” But it would seem that such a sentiment is lost on many leading pension funds and mutual fund houses. While securities lending returns could never be described as extraordinary, they can be, in absolute terms, very substantial. So why is it that some funds remain steadfastly opposed to lending? And why do those that are lending remain sceptical about the role that securities lending can play in their fund performance?

In 2002, UK pension funds endured yet another year of negative investment returns. WM consultants say that UK pension funds showed an average annual negative return of 14% in 2002, the worst annual return since 1974. The picture in the US has been similarly poor. The Independent Consultants Co-operative reported data on over 1,000 US pension funds, endowments and foundations, and showed that the median US equity portfolio lost 15% in 2002.

However, whilst there is a general acceptance of lending as a legitimate investment activity in the US, the European market still possesses a significant number of refuseniks, hell bent on ensuring their securities never get loaned out. In the 2002 National Association of UK Pension Funds annual survey, around 80% of funds said they did not lend their securities. Of course, some smaller funds may simply never possess assets that are attractive enough to the borrowing community. But it is clear that for securities lending to be perceived as an important investment activity, more funds need to come on board and start lending.

One large fund not lending told ISF: “Overall, the benefits are materially not sufficient to outweigh all the associated problems.” And a large US mutual fund, which similarly asked to remain nameless, says: “It can only ever be an offset. It is, and will remain, a peripheral activity. Securities lending will always remain on the periphery for us.”

But if it’s so insignificant, then why the requests for anonymity? Richard Warne, European head of securities lending at JP Morgan Investor Services, suggests one reason for the coyness: “You could argue that funds have a fiduciary duty to lend their securities. Not looking to lend your securities is tantamount to a dereliction of that duty.” Dan Kiefer, portfolio manager at the Californian Public Employees Retirement Scheme, agrees: “Securities lending is one of the lowest hanging pieces of fruit in the investment industry. Tell me another area where you can consistently make alpha. It would be crazy not to look at lending.”

Indeed, for ABP and PGGM, the two large Dutch pension funds that ceased lending in July of last year, the low hanging fruit has proved too tempting to pass up. In January this year, they returned to the lending fold, their outrage at short selling apparently having subsided. Neither was willing to comment on the topic, but if two of Europe’s largest funds are prepared to forego securities lending revenue for a large portion of the year, it sends a damning signal to the marginal potential lender, still unsure whether to take the plunge.

Short selling blues

The furore around short selling may have died down from the heights of last year, but it is still a concern for funds. Roy Zimmerhansl, director of global securities lending at Deutsche Bank, says: “This is an issue that gets raised quite regularly. But it has more of an impact on individual fund managers in programmes that are lending where the fund manager can veto his fund from participating.” Richard Warne agrees: “There are clearly still people out there who believe that shorting is not good for the market.”

It is not just the life assurers, either. One big asset manager, asking for anonymity, says: “I wasn’t, and I am still not convinced by the arguments put forward for the validity of short selling. If we ever decided to lend, it is something I would seek to investigate much further.”

To those at the sharp end of shorting, such views must seem antediluvian. But it is easy to see how they can persist when the mainstream press presents such a muddle-headed take on the matter. “Lack of information invariably leads to a lack of understanding and trust - it raises unnecessary suspicion about the industry,” says Charles Lowe, head of securities lending at Prudential M&G. “This debate has been a long-standing irritant that the industry should deal with, led from the front by the FSA.”

Short selling is not the only concern for institutions - risk is also surprisingly high on the agenda. George Bruce, group treasurer of the Coal Pensions scheme, says that risk control is undoubtedly the area a potential lender must focus on first: “The single most significant factor delaying a decision on lending is a lack of real information on risk. We have found that agents and principal borrowers have been reluctant to quantify risk.”

The response from the borrowing community is strident. “Where is the risk?” says Jamie Ball, head of capital markets at ABN Amro Mellon. “I fail to see it. In an agency or principal programme for example, the beneficial owner is fully indemnified against any losses.” Mark Faulkner, founder of consultancy SFI, agrees: “Risk in securities lending is over-emphasised. It is far more risky owning shares in comparison to lending them.”

Risky business?

There are some risks that lenders will want to be aware of, however - the risk that a borrower will financially fail, the risk of a collateral failure, cash reinvestment risk, legal and regulatory risk, and operational risk. The latter is an area that one of the refuseniks is keen to highlight: “We run around 30 segregated managers. A single stock could be held by any one of these managers, presenting considerable operational risk. To effectively monitor this risk we feel we would have to commit significant resources to the activity, and we simply don’t believe it is worth it.”

Within the borrowing community itself, attitudes to beneficial owner risk perception are diverse. John Piccitto, head of European sales for eSecLending, the auction-based lending firm, says: “In my opinion, management of risk is the key to winning over the trustees. Far more so than revenue estimates.” However, Richard Warne believes this is changing: “In the past, in the presentations we gave to trustees, the bulk of the time was spent outlining risk. But these days, the trustees are coming back to us and saying: ‘You are giving us many reasons not to lend. How about showing us the revenue estimates?’ Things are definitely changing.”

Incredible as it may seem though, in the UK the Robert Maxwell pensions scandal remains the ultimate deterrent for some. “It’s amazing, but in the eyes of some of the more mature members of the fund community, Maxwell and securities lending are still thought of in the same breath,” says Jamie Ball. Roy Zimmerhansl agrees: “At the time of the scandal, which let us not forget was fraud and can never be prevented, some accounts stopped lending and others delayed starting to lend. For some this deferral lasted years. Even today it is something I still occasionally hear from trustees.”

Susan Peters, ceo of eSecLending, is more inclined to think that the securities lending industry has not helped itself by failing to prevent a coherent argument on risk to the funds community: “The lack of a standard industry risk model undoubtedly causes concern amongst trustees. The industry has not developed effective and consistent risk models that completely describe the risk associated with the transaction.”

The message coming from the beneficial owners is clear - custodians and borrowers need to outline risk in a far more effective manner. “Agents must be prepared to discuss and set risk guidelines for lending programmes and provide more informative reporting on risks,” says George Bruce. “If risks are as low as is often claimed, this would benefit agents by lessening resistance to change from beneficial owners.”

Stealing the vote

In addition to risk, the suggestion that stock is being borrowed and used to vote against the interest of long-term shareholders, is also causing concern. The Laxey Partners dispute with British Land has raked up serious corporate governance issues and is currently being examined by the UK authorities. One lender told ISF he had heard of a number of instances where the borrowing of shares had been used to secure a high profile member of the investment community a seat on his company’s board.

But others within the industry suggest this is an overplayed issue. “I have never heard of a securities lending economic value being associated with voting rights –Laxey was just very unusual,” maintains Richard Warne. The suggestion that it is not a big debating topic amongst beneficial owners is borne out by one potential lender who comments: “To be honest, the scenario of our stock being borrowed and used to vote against our wishes is something we had not thought of before. I am glad you have brought it to my attention!”

Within the borrowing community there is very little sympathy for lenders in this area, with most suggesting it is up to the beneficial owner to have the correct guidelines and restrictions in place. And in most instances this is the case. Most custodians recall all associated stock when a major vote is due. “We always ask our clients whether they intend to vote or not,” says Jamie Ball. “Our policies are guided by our clients. Most custodians tend to do the same.” But George Bruce doubts this issue is as clear cut as the custodians would have him believe: “With shareholder activism on the increase, this is likely to become a bigger issue, with more frequent recalls when votes are imminent. Some agents only offer voting on a best endeavour basis. That may not always be good enough.”

Transparent argument

Alongside the hot topics of short-selling and corporate governance, that hardy perennial lack of transparency is always guaranteed to cause potential lenders some sleepless nights. “The key issue for this business is transparency,” confirms Charles Lowe. “It is essentially a low risk, low return business, but a lot of my time has been spent with clients explaining these issues, so they can understand the dynamics of securities financing.” Kevin Mirabile, managing director of securities lending at Barclays Capital in New York, agrees: “The lack of transparency is still a major issue limiting liquidity. A regulator may even need to step in and enforce transparency rules such as are common in the cash and some OTC markets.”

Others are more sceptical about the role of transparency. “In my opinion, transparency is more of a talking point than an action point,” says Roy Zimmerhansl. “No-one that I am aware of has ever refrained from lending as a result of a perceived lack of transparency. A capable securities lending desk should be able to identify the market level for a stock.” He is equally sceptical of the roles that SecFinex and EquiLend will play in bringing about a more transparent marketplace: “As I predicted, SecFinex has had its major impact on process efficiency but it has also helped bring UK lending fees down. Obviously spread compression has forced fees to come down too but I believe that lenders not in SecFinex will find it increasingly difficult to lend their portfolios.”

However, Mark Faulkner believes that the role of transparency must not be underestimated: “Offering a little more understanding to potential lenders is important. Presenting the picture of securities lending as a black box, churning out money, will not see more supply brought to the table.” As far as Faulkner is concerned, transparency and education are crucial to attract non-lending beneficial owners. But he believes the industry has fallen woefully short in its approach to education: “The fund managers we deal with are highly intelligent people and going along armed with the notion of ‘educating these people’, often alienates potential lenders.” Indeed, as most funds have already been approached to lend their assets at one time or another, it is more a question of re-education rather than starting from scratch.

Susan Peters questions the way the industry has oversold the benefits of lending in the past: “Based upon overly robust estimates, there is undoubtedly a high level of cynicism in the lending community around the promised levels of revenue achievable and the levels of revenue likely in reality.” Zimmerhansl agrees: “In Europe, many traditional lending firms have historically oversold the material benefits of lending which has in many cases hindered the process of bringing in new supply.”

The final spur?

But in spite of these problems, surely the dire bear market should act as the final spur for the marginal potential lender to bring their supply to the table? John Stracquadanio, head of US securities lending at Barclays Capital, believes this to be the case: “We can point to various examples where new entrants to the market have done considerably well, given their investment plans. In some mutual fund complexes, securities lending has saved the day in creating significant revenue that would normally have been left on the table. These results have created a desire to expand the products within these complexes and find new assets to deliver to the market.”

Richard Warne agrees that current market conditions offer an opportunity for the securities lending industry: “The bear market will have a long-term effect and we as an industry need to take advantage of this dip. You must remember that although securities lending revenues are down in absolute terms, from a relative perspective they have held up well.” John Piccitto also believes that recent conditions have made the marginal lender think again about lending: “Right now, we are seeing a comeback. Funds that expressed little interest in 2001 are coming back to us and looking at the opportunity to lock in some guaranteed income during 2003.”

But sceptics suggest that the bear market will have little long-term impact on the level of supply. “In the current market conditions, when you have to explain to your boss why you’ve done so badly, I guess you’re not going to have a lot of time to look at securities lending,” says Dan Kiefer. Indeed, the biggest single factor undermining the advent of new supply from the marginal lender is simply that many trustees lack the time to review the process.

“The Coal Board pension scheme trustees meet for one or two days a quarter to discuss investment issues,” says Bruce. “They have asked for one report a year on securities lending, when there is an opportunity to review our approach. So the lending programme evolves slowly as trustees will only authorise one cautious step at a time.” This approach is mirrored by another big fund house currently reviewing the idea of starting a lending programme. “We have been looking at the various options for over 18 months,” says the administrative officer. “From a position of not lending, getting educated and looking at our options, it has taken us a long time.”

But why should it take institutions so long to decide? Richard Warne suggests a number of reasons for the delay: “The lead time tends to be very long for legal reasons. But the role of consultants lengthens the lead time too. They provide a useful educative service but of course their interests are not always best served by a shorter process.”

Industry players should not be downhearted, however. Just be encouraged by the fund manager who commented: “We do lend assets, gaining revenues of around 1.2 basis points. I find it very difficult to get excited about that. But looked at in absolute terms, millions of pounds cannot be sneezed at! It would be ridiculous to ignore such an opportunity.”