Whether you invest in funds or individual stocks, the practice of securities lending is something you need to understand fully. Unless you're completely aware of how securities lending works and the impact it can have on your portfolio, you could end up missing out on substantial profits -- or even worse, giving those profits away to the companies that are supposedly watching out for your best interest.
Later in this article, I'll go into more detail about how securities lending works and why it's a potential threat. First, though, let's take a look at why you need to be aware of potential conflicts of interest with the companies whose job it is to handle your investments.
A conflict of interest
Millions of investors rely on financial institutions to help hold and manage their investments. Whether you have a professional manager through a mutual fund or ETF, or you manage your own money in a brokerage account, you need various fund managers to brokerage companies to act in your best interest.
Unfortunately, the financial institutions that help you and millions of clients like you also have their own business interests to deal with. In securities lending, the resulting conflict of interest can cost you a substantial amount of money.
Securities lending and you
The practice of securities lending has been going on for a long time, but it's gotten much more important in the past decade. The gist of securities lending is pretty straightforward: Funds and other financial institutions such as insurance companies and pension funds often get permission from investors to lend out the securities that they own in their portfolios. Under the arrangement, the party borrowing the shares provides collateral to your fund, and in exchange, your fund earns a bit of extra income. The same holds true for brokers who hold your stocks in a margin account, many of which arrange for the right in your brokerage agreement to lend out shares.
At face value, that seems like a reasonable practice. But since the financial crisis, it's been clear that the assumption that financial counterparties to securities lending transactions are far from risk-free, and under certain circumstances, investors can end up holding the short end of the stick.
Back in 2010, I warned investors about the potential for pension funds and other institutional investors to reinvest the collateral from securities lending in risky assets, which could essentially result in leveraged positions that could cause catastrophic losses. But in addition to that concern, the other big question is who benefits financially from the practice. For custodial specialists Bank of New York Mellon (NYSE:BK) and Northern Trust (NASDAQ:NTRS), securities lending services are a big part of their overall revenue.
Some financial institutions are trying to shine light on the securities lending arena in order to open up opportunities to a broader range of clients. Last summer, Fidelity began a pricing service that would allow its institutional clients to compare offered securities lending rates from different borrowers, making it easier for them to choose the best deals. That was a threat to Goldman Sachs (NYSE:GS), JPMorgan Chase (NYSE:JPM), and other investment banks, which had previously taken advantage of the relative lack of transparency to preserve markups for themselves.
Individual investors have a tougher time taking advantage of securities lending, but Interactive Brokers (NASDAQ:IBKR) has been a pioneer in the industry. Interactive Brokers has a program that lets ordinary investors see how much income securities lending can produce and then enter into a direct sharing arrangement with the broker to reap a portion of that income.
Fund investors, though, are at the mercy of their fund management. Often, managers retain the right to keep a portion of securities lending proceeds, essentially pocketing cash that investors are entitled to. For instance, a recent Wall Street Journal article cited figures stating that BlackRock keeps 35% of securities lending revenue for itself, while State Street hangs on to a more modest 15% and Vanguard pays everything back to its ETFs. With securities lending providing 4% of BlackRock's total revenue in 2011, those proceeds are serious business -- and fund shareholders can't afford to let that money move into managers' pockets unnoticed.
Keep your money
To protect yourself from securities lending abuses, it's essential for you to understand the guidelines under which the companies that hold your money operate. Otherwise, you may end up not getting fair compensation for the actions money managers are taking on your behalf.
Dan Caplinger owns warrants on JPMorgan Chase. You can follow him on Twitter @DanCaplinger. The Motley Fool recommends Goldman Sachs, BlackRock, and Interactive Brokers. The Motley Fool owns shares of JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.