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Before we dive into Vanguard’s approach, can you briefly describe securities lending?
Comegys: It’s a common practice among asset managers, and can include mutual funds, both active and passive, along with trusts, pensions, insurance, sovereign wealth funds, and so on. The asset managers lend securities from their portfolios to banks and broker-dealers, whose clients, in turn, use the borrowed securities for short selling or other strategies.
In exchange, the lending asset manager gets a fee and collateral. The latter, usually cash, is reinvested in fixed income investments for additional revenue. That additional revenue is typically very modest.
However, an effective securities lending program can generate additional income for fund investors that meaningfully offsets a fund’s expense ratio. Lending revenue becomes a more prominent differentiator as operating expenses continue to fall, due largely to “the Vanguard effect.”1
Does the additional revenue from securities lending always go back into the fund?
Comegys: At Vanguard, yes. We return all of the securities lending revenue, net of our expenses incurred in running the program, to Vanguard funds and, ultimately, to the fund shareholders. We keep our lending program expenses very low—around 3%—so about 97% of the gross revenue goes back to the fund shareholder. This is a somewhat unique approach, as some asset managers keep upward of 19% of gross revenue for themselves to generate income for the company, known as a “fee split.”
We believe that since fund shareholders are bearing 100% of the risk, they should get 100% of the profits.
We often hear talk about value versus volume lending. Can you explain the difference?
Comegys: Value lending is akin to getting the most bang for your buck. We follow this practice, lending out securities that are in short supply and, therefore, demand a premium. Combine this with fewer securities out on loan and a conservative collateral investment that still generates reasonable interest, and you get more attractive risk-adjusted returns.
Volume lending, on the other hand, is just what it sounds like—lending low-margin securities that require higher volumes or riskier collateral investments to generate just a bit more net revenue. Overall, you have higher exposure and lower liquidity if things go wrong.
Some firms may employ a version between these two varieties, but we’re firmly in the value camp.
What are the risks involved with securities lending?
Comegys: The risks associated with well-funded securities lending are low, but they do exist. There’s risk that the borrower cannot return the securities, for example. However, we mitigate that risk by requiring our loans to be overcollateralized. The greater risk is the lender losing money with the reinvested cash. That’s exactly what happened with a few firms during the global financial crisis about 15 years ago. A lot has happened in the industry since then that mitigates those risks, but you can’t completely remove risk.
How does Vanguard approach securities lending?
Comegys: Just as we do in other aspects of investing, Vanguard emphasizes conservatism in securities lending, seeking to safeguard shareholders from associated risks. We take an investor-centric, risk-conscious, and value-based approach.
It is investor-centric because all the net revenue goes back into the lending funds and to their shareholders. Risk-consciousness is exemplified by our stringent process as well as the reinvestment of our cash collateral only in Vanguard Market Liquidity Fund, which is an internally managed and ultraconservative money market fund. We do not stretch for yield, which is what got those other firms in trouble during the global financial crisis.
Only a small percentage of our portfolios is ever out on loan—on average, about 1% or less over the past five years—limiting our risk exposure. This, of course, ties back to the value lending that we discussed earlier. We lend out scarce securities that demand a premium. And we require cash collateral that represents 102% to 105% of the market value of the borrowed securities, which acts as a partial buffer for counterparty risk.
What types of securities do you lend?
Comegys: They’re usually small- or mid-cap stocks, or international stocks. These are in shorter supply than large-cap U.S. stocks, so we can ask for a higher premium for them.
I should note that we lend out only stocks, not bonds. With the complexity and costs associated with lending bonds, we currently believe any value generated from the practice would be minimal for investors. That said, we don’t rule out the possibility of revisiting this issue if the risk-reward dynamics change.
Any closing thoughts, Rodney?
Comegys: How a fund provider approaches securities lending can be emblematic of the firm’s overall philosophy that permeates all aspects of investing. Our securities lending program is a clear example of Vanguard’s mission to take a stand for all investors and give them the best chance for investment success.
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