September 2, 2011 4:56 pm

Investors warned on stock lending by mutual funds

Investors may be unaware that their fund managers are lending out up to 100 per cent of their fund holdings and creating so-called ‘counterparty risk’ in mainstream equity funds, a wealth manager has warned.

Research from SCM Private, which manages discretionary portfolios for clients, found that 19 out of the 20 mainstream fund managers it studied were lending out shareholdings to third parties – with private investors shouldering all of the risk that the third party might go bust.

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Just one-third of the profits made from lending the stock was passed on to investors, while the fund managers pocketed the rest, according to the research.

For fund managers, it is perfectly legal to lend out up to 100 per cent of the value of their funds. However, SCM Private said it was concerned that private investors were unable to find out enough about the process to properly assess the risks. Fund managers are not required to disclose the risks of stock lending in fund factsheets for investors, or provide any details of who they have loaned stock to - though they do have to disclose lending in the fund prospectus.

The Financial Services Authority (FSA) said that it was up to the fund manager to assess whether the risk of lending out stock was appropriate.

The Investment Management Association said that managers can only lend stock if it appears appropriate to do so, as a way of generating additional income for the fund with an acceptable degree of risk.

But SCM Private said it believed there were inconsistencies in the FSA’s approach towards warning private investors about risk.

The regulator warned earlier this year that investors might not be able to fully understand the risks of exchange traded funds (ETFs) that engage in stock lending, creating additional counterparty risk. Some ETFs already carry counterparty risk, because they rely on a counterparty bank to provide them with returns in line with an index, via a derivative contract called an ‘index swap’.

Gina Miller, co-founder of SCM Private, said: “We believe that many investors will not be aware that certain retail funds are legally permitted to potentially risk 100 per cent of their savings through stock lending.

“Clear and full disclosure regarding stock lending should be mandatory to protect investors.”

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