Securities lending is a means for pension funds to make their assets work harder. On this page, Rachel Oliver looks at how some pension funds are exploiting the market. Opposite, Mark Faulkner examines the options for those testing the water. On subsequent pages, John Lappin talks to the borrowers and we hear two points of view on benchmarking
Custodian banks would like their pension fund clients to believe they are offering their services virtually for nothing. Funds in Europe that have entered the securities lending arena have found that to be true.
Securities lending has found favour with Europe’s pension funds, albeit to a limited extent so far, as an effective tool for neutralising the costs of custodians’ fees. Though lending has by no means become a phenomenon in Europe - admittedly there are no available statistics on how large the industry is, or how much money has been made to date - it is undoubtedly a valuable extra” to those funds able to pursue the activity.
“The reason for a pension fund doing stock lending is that you can make money from it - you can sweat the assets,” says Mike Faulkner, consultant with Towers Perrin in London. “It is one of those things that is relatively easy to provide, providing you do your due diligence effectively, but is of such great benefit to the client.” The risk factor is taken care of by the custodian’s guarantee. To prevent any fraudulent activity on behalf of a borrower who might become a touch too attached to the stocks he is holding, custodians indemnify the client against broker default. So they must face the possibility of having to replace the original stocks at a higher price. But, says Faulkner, “If they manage the stock lending relationship effectively, there is no risk.” And institutional clients are becoming more aware of this fact.
The Dfl250bn ($125.5bn) Dutch scheme ABP, has been active in lending since it was privatised in 1996 and uses three custodians to coordinate the programme. Genio van der Schaft, manager, business support group, sides with Faulkner in that the benefits are most certainly the returns but the pitfalls are not paying careful attention to risk. “The benefits for sure are the revenues and since our custodian is the one who takes care of the securities lending programe, neither ABP or our investment managers are being hampered in our process,” he says.
ABP only lends a “small proportion” of assets in markets where there is “hardly any risk”. He continues: “We entered the programme under very strict conditions and we are very risk averse regarding for instance, the reinvestment of collateral. We don’t want to have any risks regarding that reinvestment, so we invest the collateral in government bonds, and high quality short term investments.”
The Dfl3.4bn Dutch Housing Trust, which has been lending for three years, was at one point even considering “going it alone”, according to William de Vries, portfolio manager. That would be a rarity in the industry. “We were looking at it some time ago, doing it for ourselves, but our organisation is not big enough or ready yet to do those kinds of things.” The fund uses Bankers Trust as custodian and sole lending provider, and as with most, the main point of the programme is “having an income enough to catch up with the costs of the custodian fees”, says de Vries. “So it is a sort of zero-sum agreement. It is also a way to make extra profit on the equities and bonds you are holding but I think the main reason was to counteract the custodian fees.”
The UK is the largest market in Europe in terms of pensions assets, but the level of activity in stock lending does not reflect this. The market is still fragmented and has limited potential for growth. UK equities represent the majority of assets held by funds but, because of the liquidity of the market, these are not in great demand. And there appears to be little correlation between the size of the fund and the level of participation.
A major fund holding more than £4bn ($6.3bn) in UK equities is the £18bn British Coal staff superannuation/mineworkers’ pension, which retreated from the securities lending market following Goldman Sachs’ takeover of the scheme’s fund management arm, CIN Investment Management, earlier this year. In contrast, the smaller £7.4bn British Airways pension fund has recently appointed Bankers Trust as its custodian, and is remaining active in securities lending. And an addition to the UK industry is Zeneca, whose £1.75bn fund joined forces with Chase, its custodian, in securities lending earlier this year. It has been agreed that a maximum of £75m (approximately 4% of the total fund) of equities “in certain markets” can be lent out. But the agreement is not extended throughout Europe. Explains Ray Martin, head of group retirement benefits: “We don’t do it because we really are a pretty insufficient size in the rest of Europe to justify it.”
The reduced risk was a major reason for the decision, says Martin: “The reason we went in with Chase was the security and the collateral they obtained, the fact that there was, in many respects, very limited risk for a small enhancement in return.”
The fund decided to remain with its current custodian “just for simplicity’s sake” and entered the market not to counteract fees, he points out, though he admits the extra return could justifiably serve that purpose. “That’s no different from saying, ‘well, if I invest in Japan rather than that and that goes up’ - that return reduces my fees elsewhere. The fees have got to come from somewhere and whether you enhance your returns from stock lending or from having a strategy in Japan that works, they both have the same effect.”
The £11bn Railways Pension fund has been active for a number of years, which perhaps explains its confidence in allowing a staggering maximum of 60% of the fund - approximately £7bn - to be lent out. But while there are no guidelines on the proportion of that sum that can be lent out or the length of time securities can stay with borrowers, awareness of the risk aspects has not been neglected, says Kathryn Long, investment director Railpen Investments, the fund’s investment management arm. “This is not a risk-free activity, which is why we are quite strict on the collateral we get back.”
The lending programme is coordinated through five managers and their custodians. “Because stock lending is a peripheral activity and the main reason that the custodians have the money is because the managers are managing the money for us, we are keen to make sure the manager who is concerned is content that the portfolio is being stock lent so that it won’t get in their way.”
She continues: “At the end of the day, we would much sooner not lend stock and not lose it, than take risks and not get our stock back.” The fund lends both equities and bonds, with the majority in the former asset class. “Properly controlled it seemed a way of making some additional money on assets that otherwise were just going to be sitting there,” she concludes.
The situation elsewhere Europe is equally erratic. Or perhaps it is m ore the case that the pensions market is still too undeveloped to consider lending viable for the time being. The Volvo pension fund in Gothenberg is still in its infancy “and it is just not the first thing you do”, says Eddie Dahl-berg, the fund’s managing director, but he says he would be willing to consider a programme when the fund matures. Nor is the Aer Lingus pension fund, which currently does not employ any custodial services, planning to enter the securities lending arena, says Bob O’Reilly, group pensions manager in Dublin. “From our superficial exposure to it, we didn’t see any great attraction in it,” he says.
Policy prevents the General Motors pension fund in Antwerp from entering the arena, while the Bfr700- 800m ($17.4m-18.7m) Raychem fund in Kessel-Lo has put its investments “under the umbrella of an in-surance company”, says François Verwinnen, tax and treasury manager, leaving it as a beneficial, not legal, owner. The securities that exist within the fund cannot be lent out.
The Sfr5bn ($3.4bn) Swiss pension fund Nestlé is active in securities lending and has been for the past three or four years, using its custodian, Pictet & Cie in Geneva, to handle a programme which looks set to either expand or sliced into two parts. “A second custodian is under consideration,” says Jean-Pierre Steiner, chief investment officer.
His reasons for being active in the area are quite simply “just to increase return and after having structured a product to minimise the risk really to almost nil - it is never nil- but to acceptable levels.” And the returns to be had are indeed very attractive, covering “at the very least, all custody fees and all related services”, he says.
There are no limits placed on what can be lent out. “Everything is available,” says Steiner, adding: “We have quotas per market which say how much we are willing to lend. Normally a money manager can recall the security whenever he wants to sell it.”
While there are no legal restrictions on it, pension funds in Denmark are yet to benefit from the added returns of lending out their stocks. The Danish tax laws treat lending of a security by a pension fund as a sale, on which a charge of 50 basis points is levied. This, by all accounts, is enough to deter any Danish pension fund from employing the service. It has certainly had that effect on the Dkr48bn ($7.4bn) PKA scheme, according to Nina Movin, head of equities. “We don’t rate it as interesting,” she says, explaining that while the tax “is still just 0.5%”, it is sufficient for the scheme to decline the service.
The situation for French pension equivalents - caisses de retraites and mutuelles - is equally undeveloped. Pascal Duval, consultant at Frank Russell in Paris assigns the reasoning to a reverse attitude to returns: “The financial return on assets is not the most important thing for the financial stake of the institution. There are more important features in the way they operate than just some basis points.”
However, he admits that the lack of activity is also due to a supply problem, which looks French custodians look set to change. “The offer has not been very developed as a product by custodians in France - they are now conscious that they have to offer all the securities lending facilities in order to be competitive, but it is a recent awareness, or a new feature for them.”