Stock lending is leaving investors short changed

Fund managers are pocketing millions of pounds in extra revenue while exposing their investors to potential risk, insiders have told The Independent on Sunday.

The highly secretive practice of stock lending – where a manager will loan a fund's shares out to a third party in return for a fee – is believed to bring millions into fund-management firms. But it seems UK fund managers are routinely pocketing a huge proportion of these revenues – sometimes as high as 40 per cent – leaving investors short changed.

"A lot of the managers are keeping 30 to 40 per cent of incomes they raise from loaning out stocks rather than passing it in full to the fund," says Alan Miller, the founder of SCM Private. "If there are any losses from the transaction, they are normally borne by the fund, therefore the investors. So it's fundamentally wrong. If investors have 100 per cent of the risk, then they should receive 100 per cent of the return."

In addition, Mr Miller says that the overwhelming majority of investors have no idea of the potential risks and rewards (to the fund-management group) of stock lending.

"A lot of investors have never been made aware their funds are doing this," says Mr Miller. "There's nothing wrong with it in itself, but investors have a right to know this is happening and how it works."

Many high-profile fund managers indulge in stock lending in return for some income, giving a portion back to the fund and keeping a large cut of it for themselves. Defenders of the practice argue that it is much like letting a house for a home-owner, and that the letting agent should be able to not only cover their costs, but keep a portion of the income.

But with the high fees charged by pension and investment funds currently hitting the headlines, the European Securities and Markets Authority is acting.

From February, the ESMA wants all fund managers to repay fees earned from stock lending back into their funds, only deducting their costs.

In addition, Alastair Kellett at Morningstar said the ESMA ruling should mean that fund managers will have to disclose in their prospectuses any fees or expenses gathered through stock lending, revealing how much is being lent out, to whom and how much income is generated, for example.

"This is a win for investors, because until now, you had no idea this was going on," says Mr Kellett.

The rules should eliminate some of the worst excesses in the market and see an uplift in investor returns.

"It's also about transparency – fund groups would benefit from being more upfront with investors," says Ben Seager-Scott at financial advice firm Bestinvest. "The most I've seen lent out at one point is 95 per cent of the stock in a fund."

When stock is lent out, the fund manager puts other stock in its place within the fund, to cover the loan in case something goes wrong.

"But it means what's in the fund isn't what you think is in the fund," adds Mr Seager-Scott.

Emma Dunkley is a reporter at citywire.co.uk