Securities lending by mutual funds can add to their overall returns.

Mutual funds, index funds and exchange traded funds (ETFs) often engage in securities lending. That is, they lend securities to third-party borrowers, mostly hedge funds and investment firms. These borrowers then mainly use them for short selling. That is, they sell the securities with the hope of buying them back at a lower price. This is, of course, a way of speculating on a share price decline.

The lending institution or fund receives all the dividends and interest it was entitled to as an investor in the security, plus a fee for making the securities loan.

There is negligible risk of losing money on the loan, since the borrower puts up collateral of at least 102% of the borrowed securities’ value. This collateral typically consists of cash, T-bills or highly rated short-term debt instruments. The borrower is liable for any shortfall between the value of the collateral and the value of the securities. If the value of the securities rises, the borrower has to add to the collateral on a daily basis to maintain coverage at 102%.

Some investors question whether institutions managing mutual funds should accommodate securities lending, which can in theory push down the value of the fund’s holdings when the security is sold short. However, this downward pressure is slight and only temporary. After that, new buyers are likely to come into the market and price the securities in comparison to prices on other similar securities.

Our view is that if a fund owns high-quality investments, securities lending won’t hurt its value or performance—in fact, it will add slightly to its total return.

BONUS TIP

Here are four rules for investing in mutual funds:

1. Get out of buying “theme” mutual funds

If the mutual fund’s theme seems to be plucked from recent headlines, stay away. It pays to stay out of narrow-focus, faddish funds, all the more so if they’ve come to market when the fad dominates the financial headlines.

Theme funds like these face a double disadvantage, because they appeal to impulsive investors who pour their money in just as the fad hits its peak. This forces the manager to pay top prices— perhaps to bid prices higher than they’d otherwise go—even if this goes against their better judgment.

These same investors are also apt to flee when prices hit their lows, forcing the mutual fund manager to sell at the bottom and lowering the mutual fund’s performance. But when a fad fades, as they all do, the fund’s liquidity dies out with it. The manager may have to dump the mutual fund’s holdings when demand is at its weakest, forcing prices lower than they would otherwise go.

2. Get out of buying bond mutual funds

Many bond funds built great performance records in recent years. But this was a function of the trend in interest rates; when rates fall, bond prices go up. Interest rates are low right now, but could move upward over the next few years as the economy recovers or in response to inflation fears. This is another way of saying that bond prices could fall.

When bonds yielded 10%, perhaps it made some sense to buy bond funds and pay a yearly MER of, say, 2%. Now that bond yields are down closer to 4%, it makes a lot less sense, and has a greater impact on your mutual fund’s performance.

The bond market is highly efficient, and we doubt that any bond mutual fund’s performance can add enough to offset its management fees. In addition, investing in a bond mutual fund exposes you to the risk that the manager will gamble in the bond market and lose money.

Bonds are attractive for predictable income, and as an offset to the stocks in your portfolio. But it’s cheaper to buy bonds directly than to do so through a bond mutual fund. If you want capital gains, buy stocks or stock-market mutual funds.

3. Beware of buying vaguely described mutual funds

Get rid of mutual funds that show wide disparities between the mutual fund’s portfolio and the investments that the sales literature describes. Many mutual fund operators describe their investing style in vague terms.

It’s often hard to find out much about who is making the decisions, what sort of record they have, and what sort of investing they prefer. We always take a close look at a mutual fund’s performance and investments to see if they differ from what the prospectus or sales literature would lead investors to expect. When the mutual fund takes on a lot more risk than you’d expect, our advice is to get out.

4. Avoid buying mutual funds that trade in derivatives

Some funds are set up to profit by trading in derivatives, based on studies of what would have paid off in the past five years, for example. But other market participants can also access that information. So, things are unlikely to work quite the same way for the mutual fund’s performance over the next five years.

In the long run, derivatives trading is what mathematicians refer to as a “negative-sum game”: one player’s gain is another’s loss, minus commissions and other costs. In the end, trading derivatives costs you money.

You should also read our other 3 mutual fund investing rules and why we prefer ETFs over mutual funds.

Do you know if you hold any positions in mutual funds or ETFs that take part in securities lending? Do you think it has positively or negatively affected your profits? Share your experience with us in the comments.