Securities lending has long been a means for investment managers to generate additional revenue and performance for investors.
Participation in the practice has increased in recent years, in part, by the highly competitive investing industry. There are over $2trn in securities on loan that generated over $8.9bn in revenue over the past 12 months, according to HIS Markit. And now with the rapid growth of ESG investing, it is important that investors consider how securities lending can co-exist with ESG, and how it may even enhance this movement.
The Risk Management Association recently issued a white paper, Complementary, Not Conflicting: Securities Lending and ESG Investment Coexist, which highlights the considerations for investors on the nexus of these two topics. It also incorporates survey results from 44 institutional investors, many of which represent some of the largest investment managers, pension funds, and sovereign wealth funds in the world. When ultimately asked the question that headlines the paper, can ESG investing and securities lending coexist, 95% of the respondents answered ‘yes’.
For some, securities lending revenue increases portfolio returns that can offset a portion, and in some cases all, of a fund’s management fee, resulting in higher net returns to investors. This dynamic has been particularly acute in the passive investing and ETF space as fund managers look to grow their businesses through lower management fees. According to Morningstar, 99% of ETF funds in the US lend their securities. Actively managed funds, some of whom may have historically characterised the practice as immaterial to their business, are increasingly looking to securities lending to derive additional performance.
Relatedly, some managers directly receive fees for providing securities lending services to their funds. These arrangements can result from the fund manager engaging a lending agent that is affiliated or performing oversight functions on an unaffiliated lending agent. This additional revenue can allow managers to reduce management fees to increase their competitiveness. Often, the use of an affiliated securities lending agent or receiving a portion of lending revenue is subject to local regulation that aims to promote investor protection and transparency.
Some in the industry, however, have questioned how securities lending and ESG can co-exist due to concerns about governance and voting rights. It’s our belief that securities lending does not undermine ESG investment and, in fact, can facilitate greater expression of ESG principled investing. Most developed markets prohibit naked short selling, or short selling without first borrowing a security through securities lending.
By facilitating short selling, investors can take a position and sell short securities of companies that have scored low on ESG scales. Through the facilitation of short selling, securities lending promotes greater price transparency of companies based on an array of investor sentiment, including ESG factors.
The most obvious intersection between ESG and securities lending is safeguarding the fund’s ability to exercise its proxy voting rights, which pass to the borrower in a securities lending transaction. This is particularly relevant for questions on the proxy ballot that may be material or contentious, as determined by the investment manager according to their ESG and corporate governance policies.
Securities lending is a highly efficient business where securities can be returned by, or recalled from, borrowers in advance of proxy record dates. A vast majority of securities lending transactions are on demand, meaning they can be closed by the securities lending agent at any time and for any reason. Recall instructions can be provided on a security by security basis or across a fund’s entire lending program. Loan recalls typically settle within the normal settlement cycle (usually two business days), allowing plenty of time to get a security back ahead of a proxy event. Additionally, funds can elect to restrict securities from being lent, mitigating the need to recall.
Securities lending transactions are fully secured through collateral received from the borrower, either in the form of cash or securities. If a fund accepts securities collateral to secure the lending transaction, they can work with their securities lending agent to impose restrictions on the types of securities that can be accepted, including in respect of ESG considerations. The fund’s lending limitations, often called parameters, are systematically screened to ensure a fund only receives collateral that is consistent with their ESG requirements.
If a fund accepts cash as collateral, they can invest the cash into secure, short-term securities and investment products that are consistent with the fund’s screening criteria.
There are specific actions investment managers and funds can take to align securities lending with ESG investing:
- Understand where securities lending and ESG intersect. As noted above, the key points to consider are proxy voting policies along with screening collateral and borrowers to ensure they meet the fund’s ESG criteria.
- Often, investment managers have separate teams that oversee corporate governance and securities lending. But increasingly these teams are much more coordinated and aware of each other’s activities and requirements. It is important to have regular dialogue and develop the necessary policies to achieve the goals of both teams simultaneously.
- Investment managers should work with their lending agent to implement lending parameters and oversight processes designed to incorporate their ESG needs into the lending programs. Most securities lending agents will provide recommendations on how to incorporate ESG needs into a lending program based on experience working with their clients around similar requirements.
- Lending agents can also be a source of valuable market data on the potential returns which can be combined with proxy materiality data to promote improved decision making around whether to recall a security. By harnessing the power of lending and proxy data, investment managers can achieve the dual objectives of complying with their ESG principles while delivering additional value to their clients.
The growth of ESG investing and securities lending clearly demonstrate the importance of both to global investors. The good news is that securities lending agents are well positioned to adapt to this change, allowing investors the potential to reap the benefits of incremental returns offered by securities lending while achieving sustainable investment goals.