Securities Lending - bad for share prices and fund performance?

By Travis Whitmore, Senior

“To lend or not to lend” has been a question regularly debated in the financial community since securities lending gained traction in the early 1970s. There is no doubt that participating in securities lending programs is a way to generate additional revenue for asset managers, the debate on the subject is about whether short-selling contributes to or facilitates price declines of underlying holdings at the detriment of overall fund performance. In fact, many would also ask the question: If an asset manager holds a long position in a stock, why would they lend their holdings to eventually enable short selling which could be counterproductive to long-term creation of value?

Short-selling, which is facilitated by securities lending, has earned a bad name in the public media especially during financial downturns1 . To evaluate whether securities lending has a negative impact on share prices (and fund performance), we wanted to take a purely objective and evidencebased approach. While lending supply can affect the level of short-selling demand and vice versa, it is critical to isolate the effect of short-selling demand from lending supply when studying the impact of securities lending on stock prices.

Over the past few decades, numerous academic studies have used a wide range of methodologies, rigorous quantitative approaches and differentiated datasets to address this question. Having analysed more than 20 studies on the topic published in high quality peer-reviewed journals, the evidence is clear in that securities lending is not detrimental to asset prices and plays a critical role in improving market efficiency and providing liquidity.

It is true that research suggests high levels of lending utilisation predict negative returns or share price declines. However, when we took a closer examination of the evidence available, we found that while shorting demand is an important bearish signal and may anticipate negative earnings surprises or analyst downgrades, lending supply is not the cause of stock price declines. In fact, the empirical evidence suggests that supply-constrained stocks tend to underperform those with higher levels of supply on a forward-looking basis.

One of the studies in our analysis was a live controlled and randomised experiment during a volatile period in 2008, and the experiment was repeated when markets stabilised in 2009.

Conducted by academia in partnership with an asset manager, a significant supply shock was artificially induced to significantly reduce loan fees and increase quantities on loan for stocks. However, there was no detectable adverse effects on security prices. This demonstrated that the supply withheld and later released in the study resulted in significant changes in loan fees but had a negligible effect on security prices.

More recent, market-wide studies pointed out that a lack of lending supply may lead to certain stocks in the hard-to-borrow universe (or “special stocks”) to be overvalued as they are hard to short, which resulted in disappointing future quarterly returns. A study (published in 2015) on the US equity market over a ten-year period found that “special stocks” with higher lending supply outperform those with lower supply.

Given that the empirical evidence suggests securities lending is not detrimental to stock prices, it should come as no surprise that studies have found funds who engage in lending outperform their peers.