Distortions Caused by Lending Fee Retention

Abstract

Using newly-mandated disclosures, we show some fund managers retain a fraction of securities lending income by employing in-house lending agents. In a model with heterogeneous investors and endogenous delegation to mutual funds, we show some funds optimally engage in lending fee retention and, as a result, overweight high lending fee stocks that endogenously underperform. We find empirical evidence consistent with our model’s predictions: active mutual funds we identify as fee retainers invest more in high-fee stocks and underperform relative to both non-retaining and non-lending funds. We also show fee retention can explain the negative relation between lending fees and future fee-inclusive stock returns.

Keywords: Share lending, short selling, mutual funds, ETFs, incentives, asset management

JEL Classification: G11, G12, G23