Using Mutual Funds for Securities Lending & Margin Loans - Mutual Fund Commentary

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The benefits of investing in mutual funds definitely goes beyond the diversification options and the returns that they provide. Often, the open as well as close-end investment companies engage in lending out a part of their portfolio securities, known as securities lending. The funds ideally lend their portfolio securities to broker dealers. This in turn is again lent to hedge funds and other investors.


The lending helps mutual funds earn higher income and boost total returns. Also, securities lending increase market's liquidity by helping brokers with extra capital for covering for failed trading bets or short positions.


Margin Loans from Mutual Funds

This also takes us to what is called the ‘margin loans' that investors can borrow using their mutual funds as collateral for loans. Investors can take a loan to buy more stocks or mutual funds. Borrowers are charged 1-4% higher than broker rate loan rates. While the borrower is not required to make loan payments, the loan is paid back once the mutual fund shares are sold. The interest compounds in the brokerage account until the shares are sold.


Using margin is more prevalent among Long/Short mutual funds, where managers often utilize the equities as margin to use short position and sell those assets expected to underperform. Long/Short mutual funds use short positions to maximize total returns.


However, there are certain hindrances associated with margin loans from mutual funds. Sales commissions and interest rates may eat into the profits that an investor may earn from selling the funds. This takes the focus back to the importance of knowing fund expenses. Lower charges will obviously allow a larger share of the capital to be invested and also help investors in earning higher profits. (Read:
Pay Less to Earn More: 3 Low-Expense Funds to Buy Now
)


Another hindrance is that during a downturn the value of mutual funds may go down, leading to margin call from brokers. Investors then needs to provide more cash to cover the losses.


Moving back to the risk associated with margins, loans against mutual funds are safer options as compared to equities. Mutual funds are less susceptible to losing value significantly as compared to equities, thanks to its nature of diversified investments.


Securities Lending

We have already stated that securities lending is the process of funds lending their portfolio securities to broker dealers.


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The following points, quoted from the US Securities & Exchange Commission, will give a clear view:


“The securities loan is evidenced by a written agreement between the fund and the borrower, terminable by either party at will.

To protect the fund from the risk of borrower default, the borrower posts collateral with the fund — typically cash, but U.S. Government securities and letters of credit are also possible — in an amount at least equal to the value of the borrowed securities, marked to market daily.

When a fund lends its portfolio securities, the voting rights and the right to dividends and other distributions on the loaned securities transfer to the borrower until the loan is terminated and the securities are returned to the fund.

When a loan is terminated, the fund must return the collateral to the borrower and the borrower must return the borrowed securities to the fund.

The fund's income from securities lending may come from fees paid to the fund by the borrowers and/or from the reinvestment of the cash collateral”.

Debating Securities Lending Risks

However the systematic risk factor is something to focus on. The Financial Stability Oversight Council (FSOC), the U.S. Treasury's Office of Financial Research (OFR), and the Financial Stability Board (FSB) have been debating on securities lending risks. In its annual report released recently, FSOC acknowledged that asset managers are “providing indemnification to securities lenders as part of their securities lending business.” Nonetheless, apart from the benefits for the asset managers, the risk potential also goes up.


FSOC mentioned: “The indemnification that asset managers provide may be a source of stress on their own balance sheets, while at the same time resulting in lower protection for the lenders relative to indemnities provided by banks.” Asset managers do not need to keep capital separately for providing indemnification. Also, they do not own any deposit funds like banks do.


Mutual Funds & Securities Lending

According to the FSOC, mutual funds comprise about 35% of securities lending. The U.S. Treasury's Office of Financial Research on other hand pegs securities lending by mutual funds to be at 18%. The Investment Company Institute
ICI
also debates the FSOC figure. It states that the 35% appears high given that the strict SEC regulations lead to securities lending being a comparatively minor strategy for US regulated funds. The SEC allows the regulated funds to lend up to one-third of their assets.


ICI also conducted a study of 500 largest U.S. regulated funds, which excludes money market funds. These 500 funds have $95.1 billion in securities on loan. Of these 500, 188 funds or 37.6% are involved in securities lending. These 188 funds have assets worth $4.17 trillion, of which 2.3% of their assets are on loan. Further, among the 188 funds, 148 of them are equity funds that have lend securities worth $75.4 billion.


According to Markit, the securities lending industry is en route to achieve the most profitable year of revenues in three years. Daily revenues earned from securities lending for US equities have jumped 20% this year.


Long/Short Equity Mutual Funds

Coming back to this category of funds, which mentioned previously utilize the equities as margin to use short position, are a safe option during market volatility. These funds use leverage, derivatives, and short positions in order to maximize total returns, irrespective of market conditions.


The following funds do not necessarily engage in securities lending, but are safe bets now.


These funds either carry a
Zacks Mutual Fund Rank #1 (Strong Buy)
or
Zacks Mutual Fund Rank #2 (Buy)
. Remember, the goal of the Zacks Mutual Fund Rank is to guide investors to identify potential winners and losers. Unlike most of the fund-rating systems, the Zacks Mutual Fund Rank is not just focused on past performance, but the likely future success of the fund.


Highland Long/Short Healthcare A
(HHCAX) seeks capital growth over the long term. The fund invests most of its assets in firms that are involved in designing, production and sale of healthcare or medicine products, services or facilities. However, it may also invest a maximum of 20% of its assets in a range of financial instruments of by non-healthcare firms.


The fund has returned 15.8% year to date and also boasts 1 year return of 22.4%. The annual expense ratio of 1.78% is lower than the category average of 1.89%.


The fund currently carries a
Zacks Mutual Fund Rank #2 (Buy)
.


Schwab Hedged Equity
(SWHEX) seeks growth of capital over market cycles that are less volatile than the equity market. The fund uses long and short positions in domestic equity securities. It purchases or sells short stocks of firms with market capitalization of at least $1 billion.


The fund has returned 6.3% year to date and 9% in the last one year. The annual expense ratio of 1.48% is lower than the category average of 1.89%.


The fund currently carries a
Zacks Mutual Fund Rank #1 (Strong Buy)
.


About Zacks Mutual Fund Rank

By applying the Zacks Rank to mutual funds, investors can find funds that not only outpaced the market in the past but are also expected to outperform going forward. Learn more about the Zacks Mutual Fund Rank in our 
Mutual Fund Center
.


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