C&B Notes

Against the Interests of Investors

Some money managers are lending securities out of their funds to generate revenue that they keep, rather than fully crediting the income to these funds.  In addition to failing a common sense test, this approach is rife with conflicts and decreases transparency:

  • Management firms gather revenue from lending securities while their clients (via the funds in which they are invested) take all of the counterparty risk – yet only receive part of the generated income.  This approach is a clear misalignment and potentially incents managers to take undue default risk because they have personal financial gain without direct financial exposure.
  • It appears that many management firms rely on this auxiliary revenue stream to enhance their profitability.  This approach obscures how they are being compensated, and effectively allows them to report an artificially low management fee.

When we lend securities, we do not take a split of these revenues.  Instead, all of the income accrues to the benefit of the fund.  This approach better aligns all of our interests.

The rules set by Europe’s main market regulator aim to ensure that fund investors gain the benefit from securities lending, a common practice across the fund management industry.

Typically shares or other assets held in a portfolio are lent to a party such as a hedge fund return for a fee, usually to aid short-selling transactions — where a speculator sells a borrowed security in the hope of buying it back at a cheaper price before returning it.

The new rules from the European Securities Markets Authority are expected to come into force from next February and are likely to hit big asset managers, particularly those with large index tracking funds or exchange traded funds business such as BlackRock.

Some industry analysts say the rules could reduce short-selling activity if asset managers decide it is uneconomic to carry out securities lending.