Unannounced to their investors, mutual-fund managers will often lend the shares they hold to short sellers who bet against particular stocks.
By doing so, a fund manager can earn a little extra money (on the interest charged) and reduce the overall costs to operate the mutual fund—hopefully passing on the cost savings in the form of a lower expense ratio to the investor.
But the flip side is that if the manager is lending out a good amount of the fund’s holdings, this means there is a lot of demand by other investors to bet against the exact holdings the fund manager has in the mutual fund.
When all is said and done, if your fund manager is lending out a good amount of the underlying portfolio, is this a negative sign for future returns? The answer is a resounding yes: Active fund managers who lend out more than 1% of their holdings on average during the year underperform their fellow mutual-fund managers by an average of 0.62 percentage point a year across multiple asset classes.
To investigate this issue, my research assistant Pamy Arora and I looked at the full sample of actively managed equity mutual funds that are U.S.-based. We then separated them along their specialization: U.S. growth, U.S. value, U.S. large cap, international and emerging markets. For each mutual fund, we extracted the average dollar value of their portfolio that they lent out to short sellers during the year and divided the funds into two groups: those with greater than 1% of their holdings lent out, and those with less than 1% of their holdings lent out. (The average percent lent out by active funds was 0.80%.) We then investigated the returns (net of expense ratio) to these groups of funds over the past 10 years.