Unannounced to their investors, mutual-fund managers will often lend the shares they hold to short sellers who bet against particular stocks.
By doing so, a fund manager can earn a little extra money (on the interest charged) and reduce the overall costs to operate the mutual fund—hopefully passing on the cost savings in the form of a lower expense ratio to the investor.
But the flip side is that if the manager is lending out a good amount of the fund’s holdings, this means there is a lot of demand by other investors to bet against the exact holdings the fund manager has in the mutual fund.
When all is said and done, if your fund manager is lending out a good amount of the underlying portfolio, is this a negative sign for future returns? The answer is a resounding yes: Active fund managers who lend out more than 1% of their holdings on average during the year underperform their fellow mutual-fund managers by an average of 0.62 percentage point a year across multiple asset classes.
Our study
To investigate this issue, my research assistant Pamy Arora and I looked at the full sample of actively managed equity mutual funds that are U.S.-based. We then separated them along their specialization: U.S. growth, U.S. value, U.S. large cap, international and emerging markets. For each mutual fund, we extracted the average dollar value of their portfolio that they lent out to short sellers during the year and divided the funds into two groups: those with greater than 1% of their holdings lent out, and those with less than 1% of their holdings lent out. (The average percent lent out by active funds was 0.80%.) We then investigated the returns (net of expense ratio) to these groups of funds over the past 10 years.
The first interesting finding is that even in the U.S. large-cap arena, we can see that if a fund manager is lending out shares, it isn’t a good sign for the fund performance. Active large-cap fund managers who lent out more than 1% of their shares averaged a return of 12.93% a year over the past 10 years. Active large-cap fund managers who lent out less than 1% of their shares averaged a return of 13.29% a year over the past 10 years. This amounts to a 0.36 percentage-point difference in returns a year.
Lending Effect
Fund managers who are more active about loaning out shares will perform worse
10-year annualized return
When we look at mutual-fund managers who have lent out more than 2% of their portfolio on average, the results look even worse for lenders. For active large-cap fund managers who lent out more than 2% of their holdings, the average return per annum over the past 10 years was 12.78%. This amounts to a 0.51 percentage-point deficit held up against the comparable funds whose managers didn’t lend out considerable shares.
The results get even more striking when we examine more-speculative areas of our financial markets. When we look at the difference between fund managers investing in international stocks, we see an annualized return difference of 0.64 percentage point a year over the past 10 years (7.03% annualized return for those lending out under 1% of shares vs. 6.39% annualized return for those lending out greater than 1% of shares). And when we examine U.S. growth funds, the difference in returns jumps all the way to 1.22 percentage points on annualized basis (14.33% v. 13.11%).
More lending, more volatility
What is also intriguing is that across all asset classes, fund managers who are lending out less than 1% of their holdings exhibit lower volatility in the annual returns of their portfolios. For instance, measuring standard deviation of a fund’s annual returns over the past 10 years for active large-cap fund managers, the average for fund managers lending out less than 1% of holdings over the past 10 years was 15.21%. For those active fund managers lending out more than 1% of their holdings, the average portfolio volatility over the past 10 years was 15.51%. This higher portfolio volatility associated with more lending holds across all asset classes studied.
Finally, with regard to the extent of the lending by managers, we do see some fund managers pushing the limits of what is allowed. In the data, we see over 2% of funds that focus on U.S. equities lending out an average of more than 20% of their underlying holdings each year—coming close to SEC guidelines for allowable shares lent out.
In total, investing in a fund manager who is lending out the underlying shares in a portfolio isn’t only going to be a hit to your returns, on average. It also means a more bumpy ride (higher volatility) along the way—and just may be a signal of an active mutual fund that you may want to avoid.
Dr. Horstmeyer is a professor of finance at George Mason University’s business school in Fairfax, Va. He can be reached at reports@wsj.com.
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