A mutual fund is typically meant to be a calm environment to watch your retirement savings grow steadily over the decades, right? Funds of course have multiplicities of positions along the proverbial sliding scale of riskiness, but these investment vehicles are generally sought out for their typically diversified nature and security.
Fund managers may be putting that classification at stake though when they lend out the underlying holdings your mutual fund contains. It's a well-known yet contested topic in the financial community called "securities lending," but one that is not too often discussed.
Securities lending, simply put
A stock mutual fund or ETF will usually hold thousands of shares of different stocks. If there is a short-seller who wants to borrow those stocks and agrees to post some collateral and pay the fund a fee for doing so, a fund will lend them out and make a little extra dough. It's a clever way to make incremental revenue by fund managers.
But, is there a catch? Could lending out your fund holdings actually be detrimental to your money in the long run?
In short... possibly
A study done by Derek Hoystermyer, a finance professor and contributor to the Wall Street Journal, found that active fund managers who’ve made it a habit of lending out north of 1% of your funds' underlying holdings in a given year eventually end up underperforming by 0.62% across multiple classes when compared to funds that don’t lend out shares.
For example, when it came to US large-cap-based funds, those that loaned out less than 1% of their holdings averaged returns of 13.29% per year, while actively managed funds that lent out more than that averaged 12.93%, or 0.36% less per year. Fund performance gets worse for those that lend out more than 2%, not to mention the fund's increased volatility.
A 0.36% annual return different looks like a small number, but for hypothetical's sake, if you had 1 million dollars invested in both a fund that lends out less than 1% of its holding and a fund that lends out more than 1%, your average account balance difference 10 years later would be roughly $107K ($3,480,000 vs $3,373,000).
For us, what we can do
But all fund practices aren't created equal. Fund securities lending policies are not uniform across the board. For example, income earned from securities lending for certain ETFs is estimated and accrued daily into its NAV which may result in returns that can partly offset fund management fees—a potential benefit.
If this seems like a matter that may be relevant for you, make sure you read the fund or fund's parent company's prospectus, semi-annual or annual report so you know what its securities lending policy is. All in all, simply be aware so you can make the most prudent decision for yourself.