ASSET SERVICING: Securities lending scrutinized

Plan sponsors have their securities lending programs under the microscope, trying to capture as much return as possible, rather than simply running on autopilot, according to industry observers.

"Every pension plan should actively manage their securities lending program and ask hard questions about risk, risk management and about whether they're getting the proper return and the proper fee split," said Susan C. Peters, chief executive officer of eSecLending, Boston, a firm that manages securities lending programs for institutional investors.

"Even asking a few simple questions … will lead to better returns," she said. "More and more (plan sponsors) are beginning to ask those questions and are probing harder on securities lending."

In the past, she said, securities lending "was viewed as extra gravy" by plan sponsors, and there was little, if any, discussion of how the programs were being handled.

Sarah M. Wotka, senior vice president, securities lending at State Street Corp., Boston, said there's been a natural evolution toward more plan sponsors actively supervising their securities lending programs, as the flow of information from the securities lending agents to plan sponsors has increased.

"People are taking more interest because there's more information out there," she said. "They're more able to evaluate and look at the securities lending program."

Edward O'Brien, an executive vice president at State Street who runs the firm's securities lending business, said he's noticed that more plan sponsors are attending industry conferences.

"It's not just the mega-size pension fund that's attending," he said. "There are a lot of smaller and midsize funds in which, even though the portfolio might not be as large and might not make as much money, in terms of percentage, it's every bit as big and meaningful as it is to the bigger funds."

"The level of questions — in the detail they ask — is generally more sophisticated and probing than it used to be," he explained. "Most clients understand the difference between the value of their underlying securities on loan and the equal importance of the collateral reinvestment process."

One plan — albeit the biggest — that understands the intricacies of securities lending and has long taken an active role in the program is the $167 billion California Public Employees' Retirement System, Sacramento.

CalPERS earned about $103 million in securities lending revenues, net of fees, in the fiscal year ended June 30, 2004, according to data from the system. That equates to a return of more than nine basis points on lendable assets.

"We look at securities lending not as a back office function but more of an investment management function," said Dan Kiefer, opportunistic portfolio manager at CalPERS, who runs the program. "It's a way to deliver alpha or additional fee income to the fund.

"With alpha declining across a variety of strategies, securities lending and otherinnovative uses of your asset base that add fee income are going to be a key differentiator," he said.

He explained that in 2000, CalPERS began to use an auction process to find a securities lending agent.

Typically, securities get loaned on a first-in, first-out basis, so a plan sponsor or other beneficial owner has to wait until their securities are at the top of the list to be loaned out.

"Our thought was that you could either be in the securities lending queue and have your securities queued in an agent-type method, or you could bypass the queue," he said. "We thought there was (economic) value (that the borrower would be willing to pay for) in having the portfolio tied up for a certain period of time with a prime broker. We tried to figure out a system that could deliver some of those economics back to us, and what we came up with was to auction (the portfolio) off."

Juan Almaguer, senior investment officer at the $26 billion Los Angeles County Employees' Retirement Association, Pasadena, Calif., said the system started taking a more active role in managing its securities lending program in 2002. That led to a restructuring of the program to include a third-party lending agent and a broker as well as the custodian, which until then had been the sole manager of the program, he said. "We believe this new structure is in line with our objective of maximizing our overall income with a reasonable level of risk," Mr. Almaguer said in an e-mail response to questions. "Since the new structure has been in place, we have seen an increase in our net income in the 20% to 30% range."

He said the LACERA program has managed that increase during a time when other securities lending beneficial owners have seen their returns decrease because of tighter lending spreads and a low interest rate environment.

Mr. Almaguer said that while he has noticed more interest from other beneficial owners of the securities in taking a closer look at their programs and learning about what others are doing, he has not noticed plan sponsors implementing big changes in their programs.

Michael Vardas Jr., senior vice president of global securities lending at Northern Trust Co., Chicago, said securities lending earnings peaked for most lenders in 2001, when equity markets crumbled and interest rates declined, and those earnings reached a low point in 2003 before turning up this year.

Ms. Peters at eSecLending recommended that plan sponsors wanting more from their securities lending programs work with a consultant. "Consultants are another pair of eyes that have access to a broad range of information regarding securities lending programs," she said. "They have the skills to critically assess them." Among the leading securities lending consultants is Callan Associates Inc., San Francisco.

Overall, she said, plan sponsors should view securities lending as part and parcel of their overall investment management.

"The fact there's more scrutiny and plan sponsors are asking questions I think is the right way to go," she said. "It's a relatively small piece of revenue compared to the overall portfolio strategy, but can still play an important role in achieving a fund's return objectives."