By Joshua Lavender and Peter J. Bassler
Securities lending, long considered an operational function, is a true alpha overlay investment product gaining more attention and respect as a stand-alone function. The business is now at a tipping point, moving steadily toward a more sophisticated model. Its evolution is mirroring that of money management as the focus moves from large custodians and migrates toward "pure play" specialist firms.
Savvy investors are bringing the same diligence and focus to this product that is directed at any other investment allocation. This change of mindset is leading to greater specialization and competition and an increased focus on benchmarking and performance. No longer blindly bundled within a custody arrangement, securities lending has come into its own as a separate and distinct asset class.
According to the ASTEC Consulting Group, an independent consulting firm specializing in securities lending, more than $4 trillion in securities are on loan at any given time, generating more than $7 billion in annual revenue. Growth is estimated at 16% annually, and the trend is likely to continue. As the hedge fund industry continues to expand and Wall Street firms continue to innovate with products to hedge, mitigate or assume risk (i.e., credit default swaps), and asset managers develop new investment strategies with long/
short components (e.g., 130/30 products) the need to borrow — the driver of demand — is likely to remain robust.
The majority of large investors (such as pension plans, insurance companies, mutual funds, and central banks) already participate, and those that have resisted must reconsider their position. The potential for revenue is well worth the effort needed to set up a well-structured program, and investors not currently involved are leaving money on the table for their shareholders and beneficiaries. The largest U.S. pension funds, for example, each earn $50 million to $115 million annually from their securities lending activities.
Historically, resistance to securities lending has focused on the misperception that lending securities would help the short sellers and drive down equity values. The other concern has been related to settlement problems. The empirical evidence for most asset classes does not support the contention that short sellers are behind long-term equity value declines, and settlement problems are rare, occurring only 0.5% of the time in well-managed programs. The added irony is firms that worry about the effect of short sellers often also allocate assets to hedge funds or run their own absolute-return strategies alongside long-only mandates.
Securities lending demands a dedicated investment perspective. Mandates should no longer simply be given to a custodian with a core expertise that revolves around performing operational functions such as clearing, settlement and safekeeping. The most successful and profitable securities lending overlay strategies are executed by firms and professionals who understand the cash markets, interest rates, yield curves and short-end investment products, as well as the supply and demand dynamics in the equity finance and repo businesses.
From an oversight perspective, the old model of investors periodically reviewing securities lending with the custody mandate is no longer acceptable from a fiduciary perspective. Investors must review their managers in this business annually and hold them accountable against an agreed-upon benchmark. Investors should demand quarterly reviews, on-site visits and attribution analysis similar to what they expect from their traditional and alternative money management relationships.
With the changing landscape, various models, including agent and exclusive, have emerged that provide more choice and competition to investors looking to restructure their programs. A consequence is that investors are diversifying and hiring multiple securities-lending managers, giving them the ability to allocate and reallocate business based on performance. Using multiple lending managers is becoming more the rule than the exception among investors with at least $30 billion in assets.
With new choices and a renewed focus, the discussion turns to benchmarking and performance. Since the securities-lending industry does not have a widely accepted benchmark (similar to the Russell 1000 index for U.S. large-cap equity managers or the Lehman Aggregate index for bond mandates), how does an investor know if their program is outperforming or lagging other available alternatives? Large plans are forming a securities-lending consortium to periodically compare notes on providers, trends and performance. These discussions will continue to shape the securities-lending marketplace. Many members of this consortium have employed a multiprovider approach that affords them the ability to have internal benchmarking. Additionally, two notable consultants — Data Explorers Inc., with its Performance Explorer analytical tool, and ASTEC Consulting — offer data services that will increasingly help investors with performance transparency.
Securities lending is coming into its own as a separate and distinct asset class. Investors are paying closer attention, options are expanding and performance benchmarking is providing for greater transparency — an evolution that closely mirrors that of money management.
As the business continues toward a more sophisticated model, investors are likely to continue shifting mandates away from generalist custodial banks to true securities lending specialists. In the future, could the unbundling of the business continue? With innovation and focus, further specialization is likely. This could lead to asset class specialists or firms that focus exclusively on the lending or the cash collateral aspects of this business.
Joshua Lavender is a fund manager and investment analyst at General Motors Asset Management, New York, and Peter J. Bassler is a director of marketing and client management in the global securities lending program of Dresdner Bank, New York.