From the desk of Roy Zimmerhansl
Practice Lead, Pierpoint Financial Consulting
The cry for increased transparency is often the first port of call in the aftermath of some type of market breakdown. As some suggest “sunlight is the best disinfectant” paraphrasing the words used by Louis Brandeis in “Other People’s Money and How the Bankers Use it” in 1914. While I’m not convinced that in and of itself, transparency is always the answer, it is often at least part of the solution. My blog last week on dividend arbitrage is one example of how a lack of transparency can undermine the legitimate and valuable contribution that securities lending makes to capital markets.
I am a volunteer member of the Investments Group of the Transparency Task Force which ‘operates as a not-for-profit with the sole purpose of driving positive, progressive and purposeful finance reform’. As part of that worthy objective, they host a series of events that explore a vast range of transparency/reform/trust topics on an ongoing basis and have a series of online symposia throughout June and beyond.
In the inaugural blog post for Pierpoint in September, we wrote: “The team here want to contribute to a securities finance ecosystem that is better understood, more transparent and welcoming of change.” As part of that goal, we are proud to be one of the sponsors for the TTF’s event on Tuesday, June 2nd: “Time for Transparency in Asset Management. Investment Consulting and Fiduciary Management”. The symposium is dedicated to discussing and debating the work that has been undertaken by various parts of the regulatory framework including of the Competition & Market Authority, the Financial Conduct Authority and the Pensions Regulator; as it relates to the Asset Management, Investment Consulting and Fiduciary Management sectors. There have been extensive investigations and ground-breaking forensic analysis into the workings of those markets. This symposium represents a great chance to take stock of all the changes that have been introduced and to consider the extent to which they are delivering the improvements that were intended.
As an event sponsor, I will be one of the speakers and the subject is near and dear to my heart. I will be touching on many of the topics below – transparency, fees and risk - and depending on time, other issues including when I think transparency is not a good thing! My guess is that some investors already lending don’t have complete answers to everything listed below and others that aren’t lending don’t have answers or worse, have the wrong ones and decide lending isn’t for them. I place the responsibility for this mainly on a business that has avoided transparency. In the daily business grind practitioners sometimes forget that the beneficiaries of securities lending revenues are often consumers - as pension fund members, investors in retail funds and are indirectly impacted through insurance premia that are affected by investment returns. Rather than an afterthought, these stakeholders should be at the front of our thoughts. As a continuation of the responsibility to consider optimal risk-adjusted returns, Scorpeo, one of other speakers will be looking at scrip dividends. (Note: ClearGlass is the sponsor for the “Costs and Charges – are we there yet?” symposium on Wednesday, June 3, providing part inspiration for this post’s title)
While many consider securities lending an arcane practice, the relevance to the fiduciary segment could not be stronger. Consider this – there are approximately €20 trillion of securities available for loan on a daily basis. Using the investor allocations as at the end of 2019, over 66% of that supply comes from pension funds and retail funds including UCITS, ETFs and mutual funds, all subject to some degree of fiduciary oversight. The published data doesn’t indicate the fees earned by those segments, but given that fees paid by borrowers have hovered around the $10 billion level for the past four years, that is a meaningful contribution to investment performance year after year. The vast majority of that money goes to the ‘funds’ but of course, vary according to commercial relationships.
Despite the value that securities lending brings to these stakeholders, as with all investment activity it carries some risk. I believe that at a conceptual level securities lending is straightforward – an investor rents out otherwise static portfolio holdings in exchange for a rental fee and collateral to mitigate risk. Nevertheless, when considering whether securities lending is complex or complicated, I choose complicated. Securities lending is complex as it has many moving parts – loaned securities, collateral movement, reinvestment decisions where cash is involved, corporate actions, free or delivery vs payment movements. Complexity, however, doesn’t mean difficult – all the items above part of the dance of moving parts that are addressed and resolved every day.
However, from a fiduciary perspective, I submit it’s complicated because there aren’t absolute answers for everything and where there are theoretical answers, the lack of transparency hinders comparison. When I teach courses on securities lending, usually pretty early on in each session and often in response to a question from the audience, I advise them that the most commonly used phrase in the business is “it depends”. Here are some examples of where that reply might be used:
· Should my fund be lending? Risk vs Reward decision with is investor-specific so requires information, knowledge and perspective.
· What are the costs, how are fees determined, and what’s a competitive fee schedule? (More on fees in a moment)
· Who amongst my peers is lending? Good luck finding a list other than some Public funds which are required to disclose. Of course, one could, in theory, dig into every financial statement to look for lending, but why isn’t it more readily available? Many retail fund regulatory regimes require disclosure it’s there, just not easily obtained.
· How much money will we make from lending? Unlike stock prices which are publicly available so can be verified by anyone with access to the internet or index level performance equally available, per security loan pricing or index performance is only available to market participants. At the index level, the first sightings of information have only appeared this year. Even to market participants, peer group performance comparisons have some flaws. Fortunately, the International Securities Lending Association is showing leadership on this issue through an investor-led working group looking at Performance Benchmarking, so we have some hope that comparisons will be more meaningful in future.
· Can we satisfy our ESG principles and goals and still generate alpha for my stakeholders? Again, ISLA is improving conditions through its establishment of the Council for Sustainable Finance at the end of 2019. However, it’s still early days and published principles need to be universally reflected in practice.
· There are also two key Risk/Reward decisions to be taken:
How do I choose the best counterparties?
What’s the best collateral to take?
· Is “Best Execution” the best outcome?
· My fund is protected by an agent indemnification – they are all the same, right? – Umm, no they aren’t.
I mentioned fees earlier. Some time ago, I was contacted by someone looking at data provided as a result of the Cost Transparency Initiative. They presented two unnamed asset managers, both of whom had funds in lending programmes. One took what I would consider to be a high fee for providing the service while the other took no fees, yet the former generated higher returns for similar portfolios compared to the latter. Additionally, there was another scenario where a portfolio manager had an extremely high percentage of the portfolio on loan throughout the year yet generated relatively small returns, and this seemed the inverse to other funds managed by the same firm that were also lending. This begs the question: ‘Are the risk/return/provider reward factors appropriately aligned?’
Given the enormous spectrum of responsibilities and obligations that fiduciaries have, it would be surprising if they had the requisite expertise to satisfactorily address each of those questions by themselves. That’s the reason they have trusted advisors, including investment consultants. I have spent a large part of my career on the other side of the table from investors, fiduciaries and their advisors, answering questions and negotiating terms, conditions and fees. Based on that experience I would argue that investment consultants are more likely to be familiar with the questions and range of answers, but they also have a wide range of responsibilities, and few possess the depth of knowledge to appreciate the impact the subtleties of this complicated practice can have on investor outcomes. While ISLA and other trade associations have been improving communication and information channels in recent years, there is a paucity of non-commercial material for “outsiders” to research and interrogate.
Whether investors choose to lend, adding to portfolio returns or not lend, avoiding risk but foregoing income, the key issue is whether they are making that decision on a fully informed basis. That’s hard to ensure given the historical opacity of securities lending, leading to assumptions for both lenders and non-lenders. And in the end, Mark Twain said it best:
“What gets us into trouble is not what we don’t know. It’s what we know for sure that just ain’t so.”