Securities Lending Fees as a Short-Term Driver of Stock Returns
Securities lending involves the owner of a security (the lender) temporarily transferring ownership of the security to an investor (the borrower) in return for compensation. Traditionally, the value added from securities lending comes from the revenue generated from the fees lenders receive from borrowers. Dimensional has engaged in securities lending for many years in its efforts to enhance returns for fund shareholders. Research by Dimensional shows that market participants may be able to further enhance their investment outcomes by using information from prices in securities lending markets to identify short-term differences in expected returns across stocks.
We examine the informational content embedded in securities lending markets by testing the relation between the price to borrow stocks, or borrowing fees, and subsequent stock performance. Using data from 14 global securities lending markets1 for 2011-2018, we find that stocks with high borrowing fees tend to reliably underperform stocks not on loan over the next several days, and that this relation is more pronounced within small cap stocks.
High fee stocks that remain high fee one year later tend to drive this underperformance. Our research shows, however, that the persistence of high fees is not systematically predictable. While the relative magnitude of borrowing fees and borrowing utilization contains some information about the likelihood of high fees to persist, their predictive power is not sufficient to reliably identify which high fee stocks will remain in that group over time.
To incorporate these research insights into a robust investment process, we need to carefully balance the tradeoffs between expected return, revenue from lending activities, diversification, turnover, and trading costs. Our findings suggest that turnover and costs can be potentially high if buy and sell decisions are triggered by stocks crossing frequently the high fee threshold. Instead, we believe that an efficient approach to incorporate the information in borrowing fees into a real-world investment process is to consistently exclude from additional purchase small cap stocks with high borrowing fees.
1 The following countries are included in the analysis: Australia, Canada, China, France, Germany, Hong Kong, Japan, Korea, Malaysia, Singapore, Sweden, Thailand, Turkey, and United States.
Securities lending involves risks. Revenue is not guaranteed and may fluctuate. Lending activities are conducted by the Custodians for the funds. Diversification does not eliminate the risk of market loss. Past performance, including hypothetical performance, is no guarantee of future results.
Securities lending is an over-the-counter market that involves the borrowing and lending of securities predominantly for the purpose of covering short-sale positions. Participants include pension funds, mutual funds, and foundations, which lend their security holdings, as well as option traders, hedge funds, and other asset managers, which borrow security holdings. These parties rely on their respective intermediaries (custodians for the lenders and prime brokers for the borrowers) to broker their transactions and manage counterparty risk. Diversification does not eliminate the risk of market loss.
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