Securities lending makes comeback with big funds

Asset owners, anticipating less-forgiving markets, continue to come back for a second bite of a securities-lending apple that left many with a bitter taste when markets seized up during the global financial crisis.

The NZ$35.36 billion ($24.5 billion) New Zealand Superannuation Fund, Auckland, revealed Oct. 17 that it had resumed lending its holdings of stocks and bonds in June, roughly eight years after shutting down its program following losses on its securities-lending collateral during the crisis.

Market veterans say expectations of leaner days ahead — even as equity markets around the world continue to barrel higher — are greasing the skids for the latest resumption of securities lending.

In a low-yield environment, the need to pursue every basis point of incremental return is driving "renewed interest in (securities) lending from clients and prospects" alike, said Jansen Chua, a Hong Kong-based managing director and head of securities finance, Asia-Pacific, with State Street Corp.

The hunt for enhanced returns is spawning an "open mindedness" when it comes to putting "very idle assets" to better use, agreed Penelope Biggs, a London-based executive vice president and chief strategy officer at Northern Trust Corp.'s corporate and institutional services.

"I can't think of a time when we've seen as much interest for the product," both from asset owners that have left and are coming back now or asset owners who are looking at securities lending for the first time," said Dane ​ Fannin, Northern Trust's Hong Kong-based head of capital markets, Asia-Pacific, and an 11-year veteran of the industry.

State Street's Mr. Chua said in Asia and Europe, pickup in interest is most noticeable now among asset owners, including insurers. In the U.S., where interest among big asset management companies has lagged that of asset owners, they may be moving to narrow the gap, he said.

State Street data show that 17 of the largest 25 U.S. managers, in terms of assets under management, "engaged in sec-lending in some shape or form; the other eight, we understand to be actively looking" at doing so, he said.

Bill Kelly, New York-based managing director and global head of agency securities finance with BNY Mellon Markets, said passive money managers have been at the forefront of the asset management industry's involvement in securities lending but more recently it's been active managers looking to join the fray.

With the huge scale of some of those active managers, and new trading strategies bringing an expanding array of assets in institutional portfolios into play, the potential for new assets to enter the industry are as strong now as any time in recent decades, said Mr. Kelly. He said industry data shows a securities-lending pool of $15 trillion to $16 trillion in stock and bond assets globally now. At present, with long-biased markets globally, the amount of assets being lent stands at just under $2 trillion, down from $3.5 trillion pre-crisis.

If the need for incremental returns is powering that broad growth, for those clients returning now to the industry it's "the creativity around more structured, thoughtful lending programs" tailored to the needs and preferences of individual clients, that's … bringing them back to the market," Ms. Biggs said.

NZ Super, in the annual report for its June 30 fiscal year released Oct. 17, listed its implementation of a securities-lending program as an achievement that would help the fund "generate additional return (and) manage collateral in the most efficient manner possible."

Management of the collateral received a decade ago from borrowers of New Zealand Super's stocks and bonds proved to be the weak link in the fund's previous securities-lending chain. When markets seized up during the financial crisis, NZ Super suffered losses "of NZ$187 million ($128 million) on the cash collateral being managed by (NZ Super's agent) eSecLending in a commingled fund," said a New Zealand Super spokeswoman in an email.

eSecLending spokeswoman Meaghan Monson didn't respond to emails and phone messages.

Mark Fennell, New Zealand Super's general manager, portfolio completion, said the changes his fund made from its prior program — setting the terms of "what we'll lend, who will borrow, how we manage the cash" — echoes moves by other asset owners that suffered losses during the financial crisis.

Even so, the program put in place, after studying those of asset owners overseas, is probably "more on the conservative side (compared to other) programs you might see around the world," said Mr. Fennell.

Like many programs now, NZ Super has opted to have its collateral managed in a separate account, with the fund's investment team determining the "re-investment guidelines, credit ratings, securities types and duration," said Mr. Fennell.

Meanwhile, in line with industry trends, more borrowers are offering non-cash collateral, often in the form of high-quality sovereign bonds or investment-grade bonds, which account for a "high proportion" now of the fund's collateral pool. For NZ Super's previous program, "nearly all of the collateral provided to us as a lender was cash," said Mr. Fennell.

The New Zealand Super executive declined to say how much in incremental returns his team hopes to receive from its securities-lending activities. If the program meets expectations, it will be a "worthwhile number," he said.

The trend toward customization of securities-lending programs makes it difficult to say how much incremental yield clients can gain by lending out their stock and bond holdings, noted Mr. Fannin.

Meanwhile, what counts as worthwhile is in the eye of the beholder.

The $213.7 billion California State Teachers' Retirement System, West Sacramento, in its annual report for the fiscal year ended June 30, 2016, called the more than 4 basis points in incremental income, or $112.9 million, CalSTRS' securities-lending program garnered that year a welcome, steady source of incremental income.

By contrast, in April, the board of the $23.3 billion San Francisco City & County Employees' Retirement System voted to shut down its securities-lending program, after concluding the less than 3 basis points its program was likely to deliver couldn't justify the distraction, for the board and investment staff, from focusing on higher-risk, higher-reward opportunities.

Josh Galper, managing principal of Concord, Mass.-based Finadium, a research and advisory firm focused on the securities and investments industry, said that divergence of views partly reflects the advantage of scale in securities lending. Four basis points for a pension fund with more than $200 billion is more meaningful that it would be for a fund with $20 billion, while as a matter of course a bigger fund is likely to hold more of the small-cap, midcap and emerging market stocks that command higher fees from borrowers, he said.

Mr. Fennell said the broadest change in New Zealand Super's new program from its first go-round is the "recognition that securities lending is really a front-office activity for an asset owner," as opposed to the back-office administrative function of yesteryear, requiring all the resources and oversight of any other investment activity.

Some veteran pension fund executives say that's a hurdle prospective securities-lending returns can't always justify.

Charles Van Vleet, chief investment officer of Providence, R.I.-based Textron Inc.'s $6.3 billion defined benefit plan, in an email said he isn't pursuing securities lending now — even though improvements in structuring sec-lending programs in recent years make it tempting to do so.

"The problem for me is time commitment and risk relative to payoff," said Mr. Van Vleet.

"A properly structured program, with no collateral risk, is only earning the intrinsic spread," he noted. "General collateral intrinsic spread is maybe 10 (basis points)," and while that can be improved by only lending stocks and bonds in high demand, "designing such a program, and the ongoing time to oversee the program, eats up too much time," he said.

With a broad array of innovative products and approaches to consider, it is important to budget where your time is spent, he said.