It’s a little known fact that MANY mutual funds practice securities lending. Securities lending entails taking portfolio holdings, loaning them to another firm, and collecting interest on that loan.
Why would anyone want to borrow securities? Simple – traders sometimes sell the market short – called “short selling”. Short selling is borrowing a stock or bond, selling it at current market prices, then buying it back at “hopefully” lower prices. Short selling is a trading strategy – NOT a long term investment strategy!
What you probably also don’t know is that Dimensional Funds DOES in fact lend out securities and collects interest in order to benefit the portfolio performance by the amount of interest earned on the securities loan.
Another article by Weston Wellington at DFA Funds details some recent commentary by Wall Street Journal author Jason Zweig:
In a recent article, Wall Street Journal columnist Jason Zweig takes a look at securities lending practices among various mutual funds and finds, in some cases, cause for concern. “Securities lending is sensible and beneficial in the right hands,” he observes, “but can wreak havoc when it is done wrong.” Last year’s turbulent fixed income market led to problems in unexpected places such as money market funds or short-term “enhanced cash” strategies, and a number of lending programs experienced losses associated with reinvestment of collateral backing the securities on loan.
Zweig’s principal gripe is that some fund sponsors keep a portion of the lending revenue even though loaned securities belong to fund shareholders and they bear the risk associated with such activities. He notes approvingly that T. Rowe Price Group and Vanguard Group “rebate all securities-lending income (net of expenses) back to the funds that generated it.” Although not mentioned in the article, Dimensional funds likewise receive 100% of any net lending revenue.
Zweig’s article suggests that fund investors and their advisors should pay close attention to securities lending practices, the allocation of revenue, and the financial incentives for those providing lending services to the fund.
A description of Dimensional securities lending practices appears on page 80 of the DFA IDG/DIG prospectus dated February 28, 2009, and a related risk discussion appears on page 16. A table on page 36 shows net lending revenue for the fiscal year ending October 31, 2008 for twenty-seven funds, with the funds earning a total of $182,252,000. The resulting performance enhancement among these twenty-seven funds for the fiscal year ranged from 0.04% for US Large Company Portfolio to 0.66% for Japanese Small Company Portfolio.
Dimensional’s Research group is preparing a more detailed review of securities lending programs, including a discussion of recent problems. Look for it on our website in the near future.
