Questions over risk and transparency, which are normally reserved for synthetic exchange-traded funds (ETFs), can also often be raised with many traditional open-ended funds. Much like with synthetic ETFs, the industry needs to address the transparency of its products, risks associated with counterparties and issues with collateral. Investors in open-ended funds should not be complacent.
Open-ended funds that use derivatives, for example, often do a poor job of communicating their exposures. While contract values are given, it is rare that investors can get good insight into a fund’s exposure to a given counterparty and economic exposure to a derivative as a percentage of assets. Even at the aggregate level, firms may simply provide net exposures in their fact sheets rather than giving information on long and short exposures separately.
The Long and Short of It
This matters, for example, because if a manager has long positions in financials worth 30% of their portfolio, along with a 30% short position, the net exposure to financials would be reported as zero, but the fund’s gross exposure is 60 per cent. The long and short returns may net effectively against one another, but poor stock selection could result in a decidedly large portfolio impact from a 0% net position.
At Morningstar we believe that, wherever possible, funds should give investors a clear disclosure of their long, short and net exposures to individual instruments, their issuers, economic sectors and asset classes. This would be in addition to disclosure of the instruments used to obtain the exposures and details of the largest counterparties.
Like the use of derivatives, securities lending is an all-too opaque area. It, too, carries issues that investors need to be aware of. While investors assume their fund retains the assets it invests on their behalf, most funds in fact lend out portfolio securities as a matter of routine. This is not in itself bad. Indeed, the essential goal is a good one: to make money for the fund on the interest paid by the borrowers of the securities.
The problem then is that there is very little disclosure. Investors should know, for example, how much of a portfolio is on loan, which shares are involved, and how much and what collateral is held. This information is rarely highlighted for investors even though it is their property that is being lent. Indeed, we would hazard a guess that most advisers are not aware of the percentage of the assets in their clients’ funds that are on loan at any given time, or the collateral held.
Conflicts of Interest
Potential conflicts of interest with respect to securities lending are also rife and would benefit from further transparency. In the first place, one question is who the firm can lend to and how the fund (owned by investors) can be assured of benefiting from such arm’s-length transactions. If the asset manager serves as the lending agent for the fund and loans the securities to itself, for example – a situation not unheard of – who ensures that the deal is a fair one to the fund owners in terms of the interest paid?
A related issue is where the revenue from securities lending actually goes. In most cases, asset managers take a portion of the securities lending revenue to pay themselves for acting as a lending agent. Once again, investors have no way to know if they’re being treated fairly or not.
To be clear, I am not advocating against the use of derivatives or securities lending. Both can be of great benefit to investors if well managed and accompanied by sufficient transparency. However, there needs to be much more openness in order to ensure investors are operating with sufficient knowledge to gauge their risks.
The original version of this article was published in Investment Adviser, part of the Financial Times Group.
