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Be sure to also read A Brief History of Mutual Funds.
Traditionally, when an investor shorts shares, the stock they are using is borrowed from their broker. In recent years—as trading has become more popular—that borrowed stock has come from some of America’s largest mutual funds.
Securities based lending is basically the process whereby a mutual fund, insurance or other pension fund will hand out its shares to other investors to short. Under a fund’s securities lending program, the investor borrowing the shares provides some sort of collateral to the fund and the fund earns a bit of extra fee income. Mutual funds—along with exchange traded funds (ETFs)—are quickly becoming big-time players as they feature large and relatively static portfolios. According to the Federal Government’s Financial Stability Oversight Council (FSOC), mutual funds currently comprise about 35% of the total amount of securities lending and borrowing. However, that number continues to surge upwards.
Now, the Securities & Exchange Commission does regulate securities lending within mutual funds. A mutual fund must publicly disclose that it may lend securities. That info will be in the prospectus. Additionally, a fund will prepare financial statements twice a year. These statements—filed with the SEC and made available to shareholders—show what securities are out on loan, investment of the collateral, a liability reflecting the obligation to return the collateral at the conclusion of the loan, and income earned from securities loans.
Be sure you are familiar with How to Read Your Annual Mutual Fund Report.
And there are some risks.
When a fund lends the stocks, these assets are not actually part of the fund, the put-up collateral is. Typically, U.S. Treasuries or cash is used. However, in recent years everything from mortgage backed securities and derivatives to letters of credit and other exotic I.O.U.’s have become commonplace. These sorts of instruments fluctuate in price and must be marked-to-market daily. That can actually affect the net asset value of the mutual fund if they swing rapidly. An additional risk is if the mutual fund invests that money in something less than desirable to juice returns.
Secondly, if the collateral drops in value by too much, the investor borrowing the shares may be forced to add additional collateral or cover the short early. If they can’t, the mutual fund and its investors are on the hook for the damage.
It can also help reduce the overall expenses of the fund as well. Mutual fund sponsor Vanguard gives 100% of its fees generated from securities lending back to its shareholders. This is one of the main reasons why Vanguard is able to offer rock-bottom expense ratios. In some cases, fees from securities lending pays for virtually all of the mutual fund’s operating costs.
See our list of the Cheapest Mutual Funds for Every Investment Objective.
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