Someone told me yesterday that successful people read and failures watch TV. I read this article with the TV on in the background, I can’t remember what was on but the article grabbed me and it grabbed me again when I found it had been written by a young consultant from LCP called Jennifer Davidson. Well done LCP for finding gifted young people and for dragging people like me away from television!
Jennifer Davidson of LCP
Elon Musk was probably happy: an announcement had just come out of Japan that would go on to spark much debate in investment circles. On 3 December 2019, Japan’s GPIF announced it was completely suspending stock lending in a move prompted by its concerns about responsible stewardship. The first question you might ask is: who, or what, is Japan’s GPIF, and why does anyone care? Well, you may be surprised to hear that the world’s largest single asset owner is not the Norwegian or Abu Dhabi sovereign wealth funds, but the Japanese government’s Pension Investment Fund (GPIF) with over $1.3 trillion in assets. As such, Japan’s GPIF has enormous influence on the investment market.
When they say something (which doesn’t happen often), the market listens. This move prompted three big questions for many other investors: • What is stock-lending and what are the risks? • Why did the GPIF stop? • What, if anything, should you do in response? Stock lenders are usually long-term holders that rarely trade the shares they hold, such as index-tracking funds. If you are invested in an index-tracking fund, it is likely that your fund routinely lends stock in order to generate income from the borrower fees, like in the case of Japan’s GPIF. This additional cash for just holding stocks is one benefit of stock lending
To really understand what the announcement means, you need to understand who is on the other side of stock lending. Why would someone want to borrow a stock?
The major use of stock lending is by short sellers, whose objective is to profit from a decreased stock price. How does that work?
The short seller borrows a stock (for a small fee) from the stock lender and immediately sells it at the current market price. If the stock declines in value over time, the short seller buys back the stock (at a lower price than they sold it for) and returns the borrowed stock, claiming the difference as profit.
Short selling divides opinion like little else in finance, but more on that later. Back to Japan: Japan’s GPIF cited stewardship concerns as the main reason for its suspension of stock lending. This is because asset managers are unable to exercise their voting rights on stocks which have been borrowed (the person doing the borrowing has the rights instead), and there is limited transparency of the borrowers’ voting intentions.
So the asset owner who is lending the stock cannot be sure of how these stock votes are being used, and whether they are being used in line with their views for example on climate change.
Because of these issues, GPIF will no longer lend stocks until lending schemes (who facilitate transactions between borrowers and lenders) improve their processes and allow GPIF to ensure its investments reflect its responsible investment policies. Should asset owners allow stock lending?
This is a contentious point and is inextricably linked to your philosophical position on short selling. This question will inevitably divide any group of investment professionals and can usually be relied upon for lively dinner-party conversation! Let’s look at the two different viewpoints. Many believe the existence of short-sellers is essential for accurate market pricing, to prevent overpricing caused by a market rush, and to aid liquidity. This would support the continued practice of stock lending.
From a profit perspective, the Financial Times estimates that GPIF earns revenues of about 2.5 basis points (0.025%) from lending. This sounds small, but on the GPIF’s huge asset base that is hundreds of millions of dollars per year. This additional income should not be overlooked: in some cases, the profits that fund managers have made by stock-lending has allowed them to reduce and even eliminate management fees (Fidelity recently launched a zero-fee index fund).
Taking the other view, some are vehemently against stock lending, and the short-selling it enables (such as Elon Musk, whose company Tesla has been a popular target for short-sellers) as they believe short-sellers intentionally drive down prices and are therefore profiting from the depreciation of a company’s shares. Furthermore, as borrowers gain voting rights for the stocks they hold, this enables ’empty voting’, where investors borrow shares purely with the intention of influencing a company’s democratic decisions, without necessarily having the company’s best interests in mind.
The passive investor Managers of index-tracking funds are passive investors. They do not perform in-depth analysis of each company in order to value its stock. The manager instead relies on other market participants for pricing based on supply and demand. As a passive investor you want the market to be as efficient as possible. Restricting access to certain types of investor (such as reducing the ability to borrow and short stocks) could, in the extreme, be harmful to an investor in a passive fund because it could lead to inaccurate valuations, and, by extension, investment returns.
If you are concerned about the stewardship impact of your passive fund holdings, you can ask your manager to provide information on the fund’s stock lending, and who it lends to. But it is also important to consider the whole picture including the positive influence of lending to short sellers, particularly the market influence through price discovery and market efficiency.
Many believe the existence of short-sellers is essential for accurate market pricing, to prevent overpricing caused by a market rush, and to aid liquidity.
This would support the continued practice of stock lending. From a profit perspective, the Financial Times estimates that GPIF earns revenues of about 2.5 basis points (0.025%) from lending. This sounds small, but on the GPIF’s huge asset base that is hundreds of millions of dollars per year.
This additional income should not be overlooked: in some cases, the profits that fund managers have made by stock-lending has allowed them to reduce and even eliminate management fees (Fidelity recently launched a zero-fee index fund).
Taking the other view, some are vehemently against stock lending, and the short-selling it enables (such as Elon Musk, whose company Tesla has been a popular target for short-sellers) as they believe short-sellers intentionally drive down prices and are therefore profiting from the depreciation of a company’s shares.
Furthermore, as borrowers gain voting rights for the stocks they hold, this enables ’empty voting’, where investors borrow shares purely with the intention of influencing a company’s democratic decisions, without necessarily having the company’s best interests in mind.
The passive investor Managers of index-tracking funds are passive investors. They do not perform in-depth analysis of each company in order to value its stock. The manager instead relies on other market participants for pricing based on supply and demand. As a passive investor you want the market to be as efficient as possible. Restricting access to certain types of investor (such as reducing the ability to borrow and short stocks) could, in the extreme, be harmful to an investor in a passive fund because it could lead to inaccurate valuations, and, by extension, investment returns.
If you are concerned about the stewardship impact of your passive fund holdings, you can ask your manager to provide information on the fund’s stock lending, and who it lends to. But it is also important to consider the whole picture including the positive influence of lending to short sellers, particularly the market influence through price discovery and market efficiency.
This article first appeared in LCP Vista Winter 2020
Postscript from the Plowman
Not all passive managers stock-lend , L&G has always been wary of it and I’ve worried in the past that stock lending fees are used to reinforce manager margins. Transparency is all and this article made me think of stock-lending in a more positive light.
If you enjoyed this article , you might want to read this blog which asks whether passive managers are actually doing the stewardship they claim they do. Jennifer’s contention is that you can check the quality of the stewardship of your manager by asking them about their voting (especially on lent stock). I worry that we do not always get straight answers to such straight questions.
If you have a view on this , either comment on this blog of write to henry@agewage.com.
I’ve always taken the view that the 1 or 2 or 3 basis points the larger funds may earn from securities lending is not enough.
Vanguard (maybe like L&G) have warned in the past:
“Because securities lending is a rather straightforward process, many investors have perceived it as a relatively risk-free way to increase the return on an equity or bond portfolio. However, there are pitfalls. …. [there are] risks, which were highlighted during the credit crisis, [and at the same time you] need to distinguish two approaches to securities lending: Value-oriented, or Volume-oriented strategies lending out a large percentage of easy-to-find securities and then attempting to boost revenues by reinvesting the cash collateral in more aggressive investment pools. Vanguard believes that the prudent strategy, known as Value lending which involves lending only those securities that generate significant revenue and minimising the risks by investing the collateral in low-risk money market securities, ensures a superior risk-reward trade-off.”
While I share your enthusiasm, Henry, that younger talent at LCP and elsewhere is being heard (or at least read), I still detect an air of consultants floating ideas to earn yet more fees from resource-constrained clients who may not have the time, knowledge and experience to do this for themselves.
We live in a wicked world George, as Ezra Pound put it “in the gloom the gold gathers the light about it” – let’s not extinguish the bright embers of youth with the cold-water earned from our bitter experience!