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What to Look for in DC Securities Lending Funds

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What to Look for in DC Securities Lending Funds Securities Lending in US DC Funds What to Look For Securities Lending in US DC Funds: What to Look For Asset management stakeholders are a meticulous bunch. Whether we are owners or managers of assets, we are invested in improving efficiency and we scrutinize risk and return. And in a continued environment of fee compression, we fixate over every basis point. It is then understandable that securities lending has become with agreed terms; and 3.) Operational risk, which a focal point in our industry. On its own, adding basis points derives from the increased transaction volumes and of return to fund performance is a compelling proposition. management complexity associated with a lending program. Understanding a manager’s approach to these However, complexity and a lack of transparency can make risks is a critical step in ensuring a lending program an objective comparison difficult to achieve. To provide a aligns with an owner’s objectives. framework, there are three primary dimensions asset owners and consultants should understand and evaluate to • Costs: There can be significant costs associated determine the securities lending program most appropriate with managing a securities lending program, and it is for their investment objectives. important to understand where these costs are borne, and how the various parties are compensated. While the • Returns: Returns can be relatively straightforward to fee split is often the headline expense communicated by assess, though it is important to ensure that returns are an investment manager, there are multiple ways that this measured consistently. While not a guarantee of the fee split may be calculated, and often are not the only future, historical returns provide the strongest indicator expenses paid in a securities lending program. of comparative securities lending performance, and should be presented as a percentage of total fund assets, The world of securities lending is nuanced and can and net of all costs and fee splits. easily confuse even the most experienced of investment • Risk management: The risks associated with a professionals. The objective of this paper is to provide you, securities lending program can be complex to identify the reader, with information on how to evaluate securities and measure. Investors should understand and consider lending programs, and arm you with important questions three primary types of risk associated with securities to ask investment managers to make informed decisions. lending: 1.) Reinvestment risk, which derives from the We will also provide insight into how the State Street Global reinvestment of cash collateral received to secure a Advisors securities lending program seeks to optimize the loan; 2.) Borrower default risk, which derives from a balance of risk and return to provide a program that aligns borrower’s inability to return securities in accordance our investment solutions with the objectives of our clients. State Street Global Advisors 2 Securities Lending in US DC Funds: What to Look For Returns Securities lending returns are relatively straightforward dividends, which counteracts the lower lending returns. and readily comparable across asset managers. As part of These tradeoffs of lower lending returns and higher an analysis of returns, there are a few items to keep in mind. dividend yields for tax-exempt funds do not necessarily equal and cancel each other out, but do add a layer of First, lending returns are generally stated in basis points complexity to the analysis. Therefore, when comparing and represent the net annual lending return to the fund returns between lending funds, it is critical to understand divided by net assets in the fund. This practice is relatively the funds’ tax status, and its impact on securities lending standard, but it is important to confirm that figures provided and dividend returns. Recognize that a taxable fund may are net of all costs and fee splits, and are provided relative to reflect a higher lending return, but the return may be more total assets of the fund as opposed to lendable assets or some than offset by a lower dividend realization rate. other measure. Second, the tax status of a fund that invests in foreign Questions to Ask a Lending Manager securities can impact its lending returns. Generally, retirement funds1 are entitled to lower withholding tax 1. Are the returns you indicated net of all fees, and rates on foreign dividend income compared to taxable reflect returns realized by the fund? Are the returns funds. This translates into lower securities lending returns represented relative to total assets of the fund? than a taxable fund may otherwise achieve. On the other 2. Does the fund benefit from preferential withholding hand, the tax-exempt fund will receive a larger portion of tax rates for retirement funds on foreign dividends? State Street Global Advisors 3 Securities Lending in US DC Funds: What to Look For Risk Management While securities lending returns are generally well rise, corporate actions may become more complex to understood, securities lending risks can be more complex manage, and increased transaction volumes heighten to understand. There are three important types of risks traditional non-lending operational risks. that investors should consider: 1. Reinvestment risk derives from the reinvestment Reinvestment Risk Management of cash collateral received to secure a loan, and the risk that the reinvestment fund declines in value. Reinvestment risk is the most critical risk for an investor Borrowers generally post collateral in the form of to understand for three primary reasons: cash or other securities (non-cash). If the collateral is • First, reinvestment risk is generally not indemnified in a non-cash (example: US government bonds), a lender securities lending program, so the lending fund is usually will hold it for the duration of the loan and receive a not compensated if this risk is realized. fee without exposure to reinvestment risk. However, • Second, principal losses are commonly born entirely by if the collateral is cash, a lender reinvests the cash the lending fund and are not shared with the lending agent (often in a reinvestment fund) to generate returns.2 the way securities lending program revenues are. Reinvestment risk comes from this cash collateral exposure to the reinvestment fund, which typically • Third, reinvestment risk affects the entire cash collateral has traditional money market risks such as credit, pool and not just individual loan trades, thereby widening liquidity, and duration risk. the breadth of potential impact. 2. Borrower default risk derives from a borrower’s Cash collateral is typically managed similarly to a money- inability to return securities and close a loan upon market investment, where the primary objective is request, resulting in a default. In such a case, the safeguarding the principal. In this context, there are three lender would liquidate the pledged collateral and use primary types of reinvestment risk: credit risk, liquidity the proceeds to purchase replacement securities on risk, and duration risk of the underlying cash collateral pool. the open market. This means there remains a risk that the collateral is insufficient to repurchase the 1. Credit risk is the potential for loss due to a credit securities to make the lender whole. event on one or several of the investments in the reinvestment fund. This risk is largely managed 3. already present in the Operational risk, through diligent credit analysis of the investments management of an investment fund, increases with in the pool, selection of high credit-quality securities, securities lending: the frequency of sell-fails may and diversification of credit exposures. The State Street Approach With more than $32.45 billion3 in cash assets under management, average life (WAL) guideline of 120 days, and a maximum final cash and collateral management is a core business for State maturity for all individual investments of 13 months. To best Street Global Advisors and not simply a byproduct of securities manage duration risk, our cash management team is also lending. This focus and scale of the business allows us to deploy integrally linked to, and in constant communication with, the resources and capabilities necessary to effectively prioritize the lending agent to manage asset- liability dynamics of the safety of principal as a primary objective of cash management securities lending program. Further, our collateral reinvestment along with liquidity and competitive returns. As such, we employ pools are also managed with a maximum 60-day weighted a prime reinvestment strategy that generally follows Rule 2a-7 average maturity (WAM) guideline. We do not believe that more guidelines with regard to quality, maturity, and diversification.4 aggressive reinvestment strategies align with our objective To manage the reinvestment pool’s credit risk, we employ a team of capturing intrinsic value in the securities lending program. of credit specialists dedicated to the analysis of underlying Instead, they expose investors to additional reinvestment risk instruments. As for liquidity risk management, the portfolio is which may not be fully appreciated, understood, or in line with actively managed for liquidity within a maximum weighted the investor’s objectives. State Street Global Advisors 4 Securities Lending in US DC Funds: What to Look For 2. Liquidity risk is the potential for loss from the Reinvestment risk can be avoided entirely through the use forced liquidation
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