Is Your Mutual Fund Lending Securities?

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Recently, I discovered that two funds - one, a closed-end fund; the other, an ETF -had engaged in securities lending to help boost income.  Some mutual funds lend securities that they own to other investors, such as hedge funds, for the purpose of shorting them.  In exchange for lending the securities, the funds receive cash collateral, which they can invest at money market rates, and perhaps a fee.  The funds continue to hold the loaned securities as an asset and also book an asset and corresponding liability for the cash collateral on their balance sheets.

I wonder whether investors in those funds realize that these fund managers have essentially made it much easier for someone else to bet against the securities that they indirectly own.  In one case, the closed-end fund discloses this practice clearly.  Any investor who takes the time to read its financial statements would learn about the practice.  In the other, the ETF discloses the cash collateral in total assets.  An observant investor would recognize that the reported net assets of that fund excludes that cash collateral.  So that investor could make an educated guess that the ETF was lending securities.  (In this case, I called the fund company which readily admitted to the practice.)

Investors, if fully aware, would probably not look on this practice favorably.  Certainly, if I were an investor in those funds, I would write a letter to the manager asking it to stop the practice.  I recognize that the fund may lose a small amount of income in doing so, but I would still prefer that they not engage in practices that work against the value of my investment.

The practice of shorting has become much more widespread over the past two decades with the rise of hedge funds.  It presents a much greater risk today to the overall market because more investors will seek to profit from declining security prices in a weak economic environment.  Consequently, it can add to the severity of a market decline and raise market volatility.  Traders may like this, but investors should not.  Given the risk of rapidly falling share prices, it is not surprising that the SEC placed a moratorium on short selling to protect financial services stocks last fall.  What is surprising is that the SEC continues to allow shorting at all.

Proponents of shorting say that it helps make the market more efficient.  That may be true in many cases, but we do not have to permit shorting to gain that efficiency.  A potential gain from shorting can help to bring out the bad news, but it also provides an incentive to exaggerate and misrepresent which can cause undue harm to the price of a stock.  Proper and timely disclosures about company and industry problems can be achieved with less risk of exaggeration, if analysts were encouraged to discuss more thoroughly a company's shortcomings along with its strengths.  For example, few analysts focus on important financial reporting issues today.  Companies also spend little time, either privately or in open forums, discussing their financial reporting practices with analysts.  Investors must also adopt a longer-term perspective to encourage companies to make such disclosures without the fear that investors will simply sell their stock en masse whenever bad news is announced.

In my view, only designated market makers should have the right to short a stock and then, only for the purpose of providing liquidity to the market (i.e. to make trading in a given security more efficient).

If the SEC does not take steps to address the problem of shorting, investors should.  They can do so by sponsoring resolutions to prohibit their funds from engaging in the practice.  This may not eliminate the practice of shorting, but it should help to limit it.

January 20, 2009

Stephen P. Percoco
Lark Research, Inc.
P.O. Box 768
Norwood, MA  02062

(732) 763-0763

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