The title of the 1985 song “Money for Nothing” by Dire Straits is a reference to the rock stars of this group achieving a wealthy status for doing easy work by playing music for people. Some mutual funds and exchange-traded funds, or ETFs, also derive easy money through a process called securities lending.
To understand how securities lending may add additional revenues for mutual fund and ETF investors, it is important to understand how securities lending works and what the benefits could mean for you.
Mutual funds own securities that other institutions may want to borrow. According to the Investment Company Institute, certain hedge funds borrow stocks or bonds when short selling or conducting various types of arbitrage investment strategies. Investment strategies such as short selling stocks require borrowing stocks from another institution like a mutual fund company. If a hedge fund borrows a stock from a mutual fund company, it typically has to pay a fee to the mutual fund company, and the hedge fund also has to provide collateral that is at least equal to what it borrowed. This can result in two additional revenue streams for the mutual fund company: the fee the mutual fund company receives for lending the hedge fund the stock and the revenues that stem from the collateral. The collateral can provide a second revenue stream of income, because the mutual fund will typically invest the collateral in an interest-bearing account, such as a money market fund. The interest earned, while the stock is being loaned, becomes the second stream of revenue.
Several variables can influence how these revenues may affect you if you are a mutual fund or an ETF investor. Some items to consider include:
- Does your mutual fund participate? If your mutual fund does not participate, you get nothing.
- Does your mutual fund return all revenues to the other shareholders and you? Some firms return 100% of revenues earned back to the investors, and other firms do not.
- How effective is the mutual fund company at generating extra revenue, and how much risk is it taking to generate the additional revenue? Generally, securities lending is thought of as a low-risk way to generate additional revenues due to the significant collateral requirements. Still, there are always companies willing to increase the risk for potentially higher returns.
In addition to the variables mentioned above, it is important to consider the categories that your mutual fund is being invested in. Specific categories of funds tend to generate and payout higher revenues to investors. Generally speaking, emerging market stocks tend to generate higher revenues than stocks from more developed international countries, and U.S. stocks tend to generate lower revenues than both emerging markets and developed international countries. Additionally, smaller stocks tend to generate more revenue than larger stocks. So on one end of the extreme, there are small company stocks from emerging market countries that tend to have high relative revenues, and on the other end of the extreme, there are U.S. large-cap companies that tend to provide lower relative revenues.
There have not been many comprehensive studies that have successfully quantified the average amounts of revenues that mutual funds can generate from this practice along with how much of this revenue is shared with mutual fund investors. My firm’s research on this topic found that the extra revenue generated by some companies that have formal securities lending programs provided extra returns for investors ranging from less than 0.01% to 0.77% per year between the years 2014 and 2018.
To help put this into a meaningful context, let’s take a look at a hypothetical example of how this could impact an investor during a 30-year retirement time horizon. Assume for a minute that we have an investor who, through securities lending revenues, was able to boost his annual return from 8% to 8.20% on a portion of his retirement portfolio that started at $100,000. Throughout his 30-year retirement, the extra 0.20% would add $57,431 to his bottom line. (Note: This amount is not guaranteed to an investor as this is a hypothetical example intended to illustrate a what-if scenario.)
There are many things with investing that seem insignificant at first glance, but upon closer analysis, these small things combined add up to big things. For this reason, understanding the securities lending policies of the mutual funds and ETFs you own is especially important. Take the time to understand the policies of your funds by carefully reviewing their securities lending practices. This can be accomplished by analyzing a company’s prospectuses and/or statements of additional information. A little bit of knowledge on this topic can go a long way toward putting more money into your pockets; some would even argue it is a good way to get your money for nothing.