Brown Brothers Harriman
Robert Lees
13 September 2016
Robert Lees, co-head of securities lending in Europe at Brown Brothers Harriman, examines the securities lending value chain, and how fees and technology are creating opportunities to change and evolve
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Is the securities lending industry still relevant to beneficial owners?
We believe that securities lending has never been more relevant, especially as asset managers see unprecedented margin compression. The current economic and political climate means this is likely to continue for some time. It might well be permanent.
In addition, exchange-traded funds are now the fastest growing sector of the funds industry driven largely by their relative low cost. Recent Morningstar research illustrates in stark terms the compound effect of high fees on performance over time. Funds with the lowest fees consistently outperform (relative to peer group) those with higher fees. Securities lending can generate a valuable revenue stream that offsets higher management fees and trading costs, enhancing overall performance.
How are fund managers responding to increasing industry pressures?
Managers are placing greater faith in their investment skills by launching more complex products, like multi-asset strategies, to generate higher investor returns and differentiate their products. Others are embracing the low cost characteristics behind the passive sector’s success with the likes of smart beta. For either strategy there are a few common steps active managers can take to reduce costs and improve performance. These are found not in the portfolio management process, but in the post trade and operational areas, such as adopting tailored securities lending practices.
Even marginal revenue gains generated from a securities lending programme could have a considerable impact. This is why we’re seeing many managers who previously held strong anti-lending views engage in securities lending after reviewing the benefit to their clients. In the right securities lending programme, meaningful revenue can be accessed safely, helping to alleviate some margin pressure.
Disappointing hedge fund performance and fees have also been in the spotlight this year. As a core driver of demand of securities lending, should this be concerning?
Top line hedge fund performance reports have been less than stellar, but the headlines don’t reflect the resiliency of the industry. Much of the performance shortfall has been attributed to specific strategies which are understandably challenged by the extraordinary equity market volatility, central bank intervention and geo-political events.
The underlying fundamentals, however, look more robust. More hedge funds are responding to market dynamics by adjusting business models and fee structures while most of the recent hedge fund redemptions are being returned back into the industry as investors search for yields.
How is the demand side reacting to this?
One prominent hedge fund manager recently wrote to investors with a call to “cast the net wider”, in other words, to be less reliant on single bets and focus more on broad indices to generate revenue. Although this statement was specific to the fund, it highlights that the demand side is looking to go deeper and wider in strategies and investments than before, which should bode well for the need to borrow securities. We are also seeing significant investment in the quantitative space, which tends to drive the need for stable consistent borrow demand.
Do you think that talk of evolution in the securities lending industry is over-hyped?
As we think about what the future might hold, it’s worth spending some time considering the disintermediation trend impacting so many other industries. Could a new entrant disrupt the securities lending industry as Uber has done to the taxi industry or Airbnb has to the hotel industry?
On the face of it, why not? There is an extended value chain from lender, to agent, to prime broker to hedge fund that absorbs a lot of value along the way. Evolving technologies like blockchain and central counterparties (CCPs) can offer the potential for lenders and hedge funds to interact directly, allowing them to share the revenues that would otherwise go to the agents and brokers.
That said, the securities lending value chain performs a number of important functions the lender and hedge funds would either need to live without or solve themselves. Regulations have made the business more complex than ever and agents and prime brokers have a key role to play in navigating the evolving environment and managing the transfer of risk. Creditworthiness is a key consideration, and while the high credit ratings of some hedge funds might tempt some lenders, most prefer to have exposure to large banks. CCPs may offer a solution, though the model still has a way to go in achieving its initial ambitions. Technology is no doubt important, but agents and prime brokers provide other sources of supply at this crucial moment for the lender.
Technology will continue to evolve, impacting our business in exciting and potentially unanticipated ways. None of these challenges are insurmountable and the industry is constantly looking at new ways to innovate, but none are trivial. What will remain steadfast is the need to structure a securities lending programme for relevancy will to optimise performance and realise incremental gains in an ever-evolving environment.
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