Why is it when a hedge fund shorts stock its risk-adjusted performance includes its shorting activity, but when a pension fund lends a security its risk-adjusted performance typically does not include its securities lending activity? The answer is obvious. Until recently the risk-return diagnostic tools of the mainstream investment community were not extended to the securities lending business. This deficiency, however, is changing literally as I write. The 300 basis point rise in interest rates that resulted from seven consecutive tightenings in 1994 in the U.S. served as a wake-up call to many that securities lending is not devoid of risk. The key to securities lending, of course, is still to possess securities that have a temporary short supply or an otherwise positive economic benefit to a borrower, such as a dividend or tax opportunity. Astute managers, however, now recognize that lending affects both the return and the risk of the overall portfolio management process.
The process works as follows for a cash transaction. A plan sponsor agrees to allow its lending agents to lend its securities. The securities are put out on loan to a borrower, often to facilitate a short sale. The borrower has to maintain a collateral balance of roughly 102% of the market value of the lent securities. This account is marked-to-market on a regular basis. In return, the lender pays interest on the cash deposit at the so-called "rebate" rate of interest. The lending agent then reinvests the collateral amount in an investment pool, frequently composed of short-term interest rate instruments. The return from the investment pool is split between the pension fund and lender according to a prearranged fee split. At the end of the period, the borrower returns the securities to the pension fund and reclaims the collateral.
The process looks simple enough, but care should be taken when choosing and evaluating a lending program to avoid 1994-like surprises. Securities lending is an asset and liability product. The asset side is composed of the reinvestment pool and the securities on loan are the liabilities. Lenders should be concerned about the risk/return profile of the overall lending process and then inspect the asset and liability positions individually to determine the source of the overall risk adjusted performance.
At an overall or integrated level, the revenue (or total spread) from lending is determined by the expected return on the collateral reinvestment pool less the rebate rate. Risk comes from the investment pool return variability, the credit risk of the borrower, and the correlation of the components. It is important to realize that there is both market risk and credit risk in a securities lending transaction. It is comforting to see that some industry participants now provide risk metrics, such as return-to-variability statistics and/or value-at-risk measures, to assess the integrated risk-adjusted performance of lending.
A great deal of information can be garnered from knowing the overall risk-adjusted performance from lending. Yet, two lending agents can have similar integrated performance and differ greatly in technique. For example, a lender with a higher risk adjusted reinvestment side contribution is investing the collateral at a higher expected return per unit of risk. Lending agents with a more favorable lending side contribution, on the other hand, are paying a lower rebate rate per unit of risk.
Calculation and interpretation of the risk adjusted performance of the investment pool parallels mainstream mutual fund performance statistics.
Assessing the lending side risk, however, is not as obvious as the asset side risk. Credit risk arises from the lending agent and the borrower. The value of the lending side risk should be assessed in an option pricing framework. The exposure is isomorphic to a complex call option, wherein the option pays off only if the market value of the lent securities exceeds the collateral balance at the time of borrower default. If the collateral balance exceeds the value of the lent securities at the time of borrower default, the exposure is zero, as the cash is used to repurchase the securities in the open market (and any surplus is returned to the bankrupt party). The exposure of borrower default, of course, can be reduced with indemnification. But indemnified fund managers should still realize they have exposure in the event that a borrower default occurs at the same time as a lender default.
Stories flourish about the revenues fund managers generate from their securities lending ventures. Prior to 1994, this income was viewed as essentially riskless. The industry lacks a representative benchmark but this does not excuse securities lending from being held to the same standards as the mainstream investment community. It is nice to see that some leading agents in the industry now provide risk-adjusted performance statistics at each level of the lending/reinvestment process.
This week's Learning Curve was written byDon RichofState Street BankandNortheastern University.