IPE asked three pension funds in three countries – Ireland, Denmark and the Netherlands – the same question: ‘Does securities lending represent free revenue for pension funds or does it carry underestimated risks?’ Here are their answers:
Michael Nellemann Perdersen, CIO at PKA, which groups eight pension funds in the Danish social and healthcare sector and has AUM of €14bn.
“We’ve focused on equities when considering securities lending and our discussions have centred on the ethical aspects, particularly with regard to hedge funds. We see securities lending and hedge funds as being linked and currently we don’t have a mandate from our boards to use hedge funds.
“When entering new asset classes we have to be convinced our ethical guidelines are respected. When it comes to hedge funds and securities lending there are many issues to analyse. We were asked to consider a programme for securities lending where the whole point sounded like exploiting different tax rules in different countries regarding taxation of dividend. Some call it tax arbitrage but we cannot participate in such programmes.
“There are a number of other issues around this question. Hedge funds exacerbate falls in prices when they borrow to use for shorting, and then people are selling assets that they don’t actually own.
“We carried out an analysis of a programme for Danish equities, which we manage in-house, and we had discussions with different counterparts.
“And then there were the risks. There was the difference between the short-term and long-term driving effect on equity prices. Nevertheless, we decided to examine it further and move ahead by starting with Danish equities.
“The programme we considered included full collateral and an ability to call the equities within 24 hours. This feature was essential because we always want the freedom to adjust the portfolio at short notice. We have been presented to some programmes where equities could be called within three or four days, but that was much too long.
“Of course that still left a risk if prices moved very high and we did not have the full collateral, but we would be in a position where we could minimise the risk. However, at that point we realised that the profits would be very small. So we decided not to proceed given the risk and the problems we found.
“But our foreign equities are outsourced to several asset managers, and for the past couple of months we have been examining securities lending as an option for our global portfolio. But again there are some issues regarding the global custodian and so we have not yet reached a decision on the question.
“We have to consider what sort of revenues we could reasonably expect a securities-lending programme to return, and then we have some ethical issues, for example what is the purpose of securities lending, is it creating real value – for example boosting our return rate, minimising or spreading the risk, adding features to our investment strategy that we do not have already - or is it just allowing other parties to speculate against us? So far we have found more problems than advantages.”
Tom van Eijndhoven, manager securities administration at Dutch industry-wide pension fund Metalektro (PME) which has assets under management of €18bn.
“We have been doing it for at least seven or eight years and before our current programme with our present custodian which started in 2002, we examined other options like an auction or a principle through a third party. But at the time we felt that the most efficient way would be to do it through our custodian.
“It’s important for us to have an overlay programme so that our external asset managers are not hampered by our securities lending operation, and in addition we felt that if we were to hold an auction or had decided on a third-party option, we may have issues with the settlement cycles so that our asset managers may not be entirely free in getting rid of certain positions at once, and we would need larger buffers which would reduce the proceeds.
“But although acting through a custodian reduces risk it does not eliminate it. We have an agency programme, which carries an inherent risk, but in practice I feel that the risks we have on our securities lending are low and acceptable short of a major default on the market.
“So while it’s not entirely certain that we will get our securities back in time, we have measures in place that should reduce the financial risk of such a delay. And while there will always be associated costs to lining down such an operation, if there would be a major default, that’s more in theory than in practice.
“Our collateral is mostly cash but it may also be government bonds, but it is all relatively high-rated collateral. It is a fact with cash that the proceeds have suffered from the interest rate fall of the last couple of years -– it’s a weird market effect that the proceeds on securities lending should be with high interest rates than with low.
“We are aware of the issue of governance and voting related to securities lending and we have an overlay programme for governance on proxy voting. So with regard to securities lending we have taken a simple measure: we never lend out more than 95% of any single equity position, and so we always keep a small buffer available for proxy voting to ensure our presence at an AGM. Of course, it can reduce our influence at an AGM but I believe that most influence is exercised before an AGM through corporate engagement, which is part of our governance programme, and other methods.
“We also lend bonds and credits, there’s a huge credit market. We lend out anything we can lend out. Of our lendable assets we have roughly one third to 40% lout on loan at any one time.
“I wouldn’t categorise the proceeds as a nice ‘little’ earner. It’s definitely money. For example, it’s more than our custody fees.
“I wouldn’t exclude that sometimes shorting through borrowed assets is used to influence the market but I don’t think the influence is as large as is sometimes claimed. Certainly, it’s inherent in securities lending that other parties are available to sell something that they don’t have but I believe strongly that the liquidity aspect is more important than the short selling.
“But it’s not an ethical issue. There are operations within the securities lending market that enhance the market. And my opinion on the fiscal question around enhancing dividend returns by borrowing securities in another market is that European governments should harmonise their withholding tax arrangements.”
Eugene O’Callaghan, head of investment manager programme at Ireland’s €14.5bn National Pensions Reserve Fund
“Of our €14.5bn assets under management, €11.3bn is in equities, the bulk of the remainder is in bonds and all of these asset are available for lending. But our programme has only been fully in operation since the end of 2004 when we completed our entry programme to the equity markets and consequently it is not yet mature.
“Nevertheless, it brings in a nice income level although it’s not fundamental to the fund.
“I characterise revenue from securities lending as very low risk, so it’s not quite free revenue because there is some risk. But the risk attached to securities lending can generally be managed down to a very low level.
“We have adopted a low-risk securities-lending strategy managed through the fund’s global custodian. Stock is lent only to approved counterparties who meet minimum credit criteria and it is secured only against non-cash collateral in the form of fixed income securities or equity baskets.
“The risks to the fund from the current programme are very low and although that’s not to say there’s no risk at all, it would require a combination of very unlikely events for us to lose money on our stock lending programme.
“While there’s a possibility that hedge funds shorting a stock will drive its price down, ultimately its price reflects the value of the underlying company. We have a long-term investment perspective and short-term market volatility doesn’t particularly concern us.
“As our fund was only set up four years ago and has only been investing in the markets for three years, our first stock lending strategy has been to go with our global custodian. We did consider other options but we haven’t done anything to see whether we could get more revenue from our stock-lending programme. However, it is something that over time I’m sure we will consider.
“As for corporate governance issues we have put fairly standard voting arrangements in place for our assets and we haven’t yet taken it to the next stage of considering second degree questions like our attitude to assets on loan.”