Stock Lending – What is it, who does it and is it Ethical?
Traditional fund management focuses on selecting and managing a pool of underlying investments in listed companies to meet the stated investment objectives of the underlying fund.
Most funds hold between 80-120 individual share holdings and the manager will buy and sell a proportion of his/her portfolio according to his views on the economic outlook and prospects for each holding.
A feature of modern investment practice is stock lending. In simple terms the fund manager agrees to lend a particular share holding to a third party in exchange for a fee/commission on the market value of the borrowed security.
The size of the fee is partly determined by the availability of the particular security relative to the demand for that security with the value increasing if there is strong demand in the market. This cash or fee brings benefits to the owner through increased returns for the fund as a whole and reduced portfolio expenses.
This third party – normally a broker or counterparty will then seek to profit if the share price moves in the direction that they have predicted. The transaction is unwound when the borrowed securities are returned to the owner and the collateral (usually cash) is returned to the borrower.
Stock lending improves overall market liquidity but does introduce the risk of counterparty default if the broker/agent managing the loan defaults.
Who does it?
In response to a question from a client I began an exercise of contacting each of the main ethical investment fund managers in the UK to see whether they engaged in stock lending within their ethical fund portfolios.
This produced some interesting results with the overwhelming majority of ethical funds not participating in stock lending activities. The reasons given for non-participating were varied with some fund groups suggesting that it did not meant their ethical principles and others saying that the reasons for not participating were more concerned with a view that this did not bring sufficient financial return for the risks involved.
Of the core ethical providers I contacted with regards to stock lending, the following companies confirmed that they do not participate in stock lending:
CIS
Kames Capital (Formerly AEGON)
F&C
Aviva SF Fund range & Aviva UK Ethical Equity
Ecclesiastical
Rathbones
Jupiter
Standard Life
The ethical funds providers which are currently involved in stock lending are:
Aberdeen Ethical World
Henderson Industries of the Future fund*
*The Henderson Global Care funds do not participate in stock lending.
Summary
The recent dramatic increase in the volatility of global markets reflects a number of significant changes to the financial markets in recent years. The widespread adoption of electronic trading, the increasing use of financial instruments and quasi-financial instruments and twenty four hour media culture have all played a part in increasing the positive and negative swings in markets. In recent sell offs a significant element of the fall was attributed to automatic sell orders being triggered by a fall in the price of a share or index.
Although stock lending improves market liquidity by effectively allowing investors to trade in stocks they don’t directly hold, it also represents a further element of the increasingly speculative nature of investment – typified at the extreme by the huge losses run up by rogue traders. This pushes us further away from the established principle of investment which was ‘buy and hold’. The question of ‘is it ethical’ is more difficult to answer.
