Lending Securities: Which Mutual Funds Do It Best

 | Mar 07, 2013 01:58AM ET

The boards of directors of mutual funds serve a valuable role when they have securities-lending operations. They are monitors; the filings that registered investment firms submit to the Securities and Exchange Commission provide clear insight regarding the board which is associated with higher returns on such an operation.

That is the takeaway from a newly published paper by John C. Adams of the University of Texas at Arlington, Sattar A. Mansi of Virginia Tech, and Takeshi Nishikawa of the University of Colorado at Denver.

Independent, Busy, and Non-Excessively Paid Directors
The paper, Affiliated Agents, Boards of Directors, and Mutual Fund Securities Lending Returns concludes that lending returns rise as boards become more independent. For purpose of this correlation, what matters is the number of independent directors, not the independence of the chair specifically. It’s a good sign for lending returns if the independent board members are members of other boards. This may simply mean that the more in-demand directors are the better monitors, so their services are also requested in other places.

It is a good sign if the directors have “skin in the game.” Annual securities lending returns “are, on average, about 1 [percent] higher when directors own shares in the firms they monitor.”

Perhaps most fascinating, is that the effectiveness of directors as monitors - especially in the securities lending context - may be inversely correlated with their pay, beyond a certain non-excess level. The most highly compensated directors “may fear losing their positions and therefore may not adequately monitor” the lending program at issue.

The authors of this paper observe that there is a relationship between their research and that of Richard Evans et al., who recently found that lending funds underperform non-lending funds. Evans et al. attribute this to restrictions on the ability of mutual funds to sell certain stocks. They can hedge their exposure to downdrafts by lending out securities that they aren’t able to sell.

The Database
Adams et al are specifically interested in index funds, in part because the passive nature of such funds bars them from any active decision to sell securities (and reduces the recall risk to those who borrow securities from them).

Registered fund managers file annual and semiannual certified shareholder reports (N-CSR and N-CSRS respectively) with the Securities and Exchange Commission, and the securities lending data in these filings made up a good part of the database for the study. Wherever such lending forms 5 percent or more of the funds’ gross income, it must be broken down as such in these reports. Below that threshold, such income can be lumped into the “other income” category.