Turn over a rock, and you never know what you'll find. That maxim applies to the financial industry today more than ever, as investors have uncovered a host of risky strategies that mostly flew under the radar while times were good.

One relatively unknown practice used by mutual funds and ETFs is now getting more attention. For years, funds have used securities lending programs to increase revenue and lower fees. Many fund investors have little or no knowledge of these programs; until recently, few would have volunteered to learn more. However, the bailouts of Fannie Mae (NYSE:FNM), Freddie Mac (NYSE:FRE), and American International Group (NYSE:AIG) have brought risk considerations back to the forefront, shedding light on the counterparty perils that ETFs and mutual funds face from lending out securities.

How securities lending works
Securities lending, or stock lending, is the short-term loan of securities. With their large portfolios, mutual funds and ETFs are natural players in securities lending programs. Lenders engage in this activity because they can earn an incremental return on their portfolio with little risk. Risk is considered to be minimal because borrowers provide collateral, such as cash or government securities, of value equal to or greater than the loaned securities. The demand to borrow shares typically comes from hedge funds or short-sellers.

Mutual funds earn a variable fee for lending securities, depending on the supply-and-demand dynamics of the securities lent. Securities in high demand may have a fee of 40 or more basis points (0.40%), while securities with less demand may garner fees as low as 0.01%. For shareholders, distributions of income from securities lending are taxed as ordinary income.

State Street (NYSE:STT) and Barclays (NYSE:BCS) are the 800-pound gorillas of ETFs, and thus major players in securities lending. These two firms are particularly well-suited to the securities lending business, given their knowledge of numerous trading opportunities across their enormous client bases, and their ability to access large portfolios of securities.

Securities lending is highly lucrative, and it can be almost pure gravy for fund firms, since the fees generated are layered on top of fees received for managing the funds. For the fund, securities lending can help reduce its management fee. It does take a little digging to tease out the information on these programs. A good place to start is the fund's annual and semiannual reports to shareholders, as well as footnote disclosures.

An example of a fund with an active securities lending program is the iShares Russell 2000 Index Fund (NYSE:IWM). During the year ended March 31, 2008, the iShares Russell fund made $14.7 million in securities lending income, or nearly 10% of its total investment income of $153 million. Since the fund's manager, Barclays, receives an equal share of the securities lending fees, it also made $14.7 million from this program.

In contrast, the Claymore S&P Global Water Index ETF (AMEX:CGW) only dabbled in securities lending for the six months covered by its semiannual report, filed at the beginning of 2008. The Claymore fund made about $35,000 on securities lending, accounting for less than 2% of its total investment income of $1.8 million. The Claymore fund collateralizes all loans with cash or high-grade debt obligations by an amount at least equal to 102% of the market value of the securities loaned. This overcollateralization provides a cushion -- but in an age when the market loses 5% or more in a day, that protection can disappear rapidly.

During the period that a fund lends securities, the assets are not actually in the fund, exposing that fund to two primary types of risk. First, what did the fund get in exchange for lending shares, and is there the potential that the borrower may not provide additional collateral when required to do so?

The second risk relates to a worst-case scenario -- when a borrower, such as a hedge fund or investment bank, collapses and is unable or unwilling to return assets to the fund. Let's use Fannie Mae bonds as an example. A fund accepts Fannie Mae bonds as collateral, and while holding that paper, its value decreases. The agreement calls for these securities to be marked to market daily, with any decrease in value covered by the borrower. However, if the borrower fails to increase the amount of the collateral, and does not return the borrowed securities when they are due, the fund now has collateral worth less than the value of the securities lent out, and it experiences a loss in its net asset value. Given the recent market turmoil, it's not hard to imagine this scenario becoming reality.

Another potential risk: With fees running into millions of dollars, the money manager running a program also has an incentive to stretch for return. He or she could reach too far out on the risk scale, putting the fund's assets in peril.

Don't panic
A securities lending program can be very lucrative, and once markets stabilize, the minimal risk these programs present will likely once again fade into the background. As long as a fund properly screens its counterparties, accepts only U.S. Treasury securities as collateral, and marks securities to market on a daily basis, there should be almost no danger. In these times of heightened risk, however, informed investors are better able to avoid investment mistakes by doing their own research and determining how active a fund is with any securities lending program.

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