Beneficial owners will have to ensure their securities lending programmes do not conflict with their wider ESG approach to investing, Lynn Strongin Dodds is told.
The Japanese Government Pension Investment Fund’s (GPIF) recent decision to pull its securities lending programme out of its $370 billion (€332 billion) equities portfolio sent shock waves across the industry. The move has only underscored the growing importance of environmental, social and governance issues (ESG) and the need for beneficial owners to have a carefully thought-out plan for their programmes.
GPIF said it would kickstart lending if its problems regarding a lack of transparency over the final borrower and how it was using GPIF shares were resolved. In the meantime, the world’s largest pension fund would only lend securities from its bond portfolio.
Andy Dyson, the chief executive of the International Securities Lending Association (ISLA), responded by saying that the GPIF action raised important questions around ESG and other key, relevant initiatives such as the Shareholders Rights Directive (SRD) in Europe, which is due to come into effect in September 2020. The aim is to increase the transparency of communications and drive shareholder engagement levels, as well as urge investors to take a more active stewardship role in the companies in which they invest.
Even before the GPIF event, ESG had moved up the ISLA agenda and was identified as one of its five priority areas for 2020. The general observation from Dyson is that although institutional investors or shareholders may be one step removed from the day-to-day management of a company, they do have a responsibility to scrutinise the activities of the management through an ESG lens. He believes that the development of best practice and operating protocols will enable them to still fulfil their governance obligations while also capturing securities lending revenues.
To this end, the trade group is recommending that European Union rules should empower investors to fully understand the role of their securities lending programmes in the context of their broader sustainable finance strategies. It also advised that EU guidance and/or rules should be developed or reviewed to build in safeguards to avoid securities lending being used to influence key votes.
The result is that beneficial owners will be encouraged to adopt a much more holistic rather than piecemeal approach to ESG in their securities lending programmes. This is not an easy task because there is no standardisation or single definition of ESG despite the growing trend towards incorporating ESG criteria into all portfolio management processes. In fact, even the terminology is often confusing, with ESG used interchangeably with responsible and sustainable investing.
Cathrine Poulton, regional head of securities finance client management at State Street, says: “Beneficial owners and their clients cannot discharge their responsibilities and it is important that they align their securities finance programme with their in-house views and investment objectives on ESG. In practice this means customising their lending programme, such as looking at who they are lending to, collateral acceptance as well as voting, which is tied to their internal governance.”
Relinquished voting rights
Voting has long been a bone of contention. The problem is, for example, if a stock is out on loan, the voting rights are relinquished, which means the asset owner cannot engage with its portfolio companies. Again, the mandates differ among beneficial owners, with some having provisions requiring their securities to be returned for voting purposes, while others do not. Overall, market participants believe they should be aware of the annual general meeting dates to ensure that the securities are back in time if they want to voice their opinion.
For agent lenders, flexibility is the buzzword. “In order to act in the best interest of our clients, there’s a balance to strike between the revenue we can generate from securities lending and our broader stewardship responsibilities,” says Mick Chadwick, head of securities finance at Aviva Investors. “We generally recall securities in the event of a close or contentious vote. However, if the vote is for a routine scenario such as the reappointment of the company’s auditors, then the clients’ interest may be better served by leaving securities out on loan and not recalling them.”
As for collateral, Chadwick believes policies will depend on the structure. “If it is in a segregated account, as is the case with the Aviva Investors lending programme, then it is easier for the client to express a preference. However, if it is an omnibus structure, then it is much more difficult because the collateral is co-mingled.”
Short selling, short-termism
The other longstanding hot topic from an ESG perspective as well as more generally is short selling, whose activities rely on securities lending. It was highlighted in the GPIF case and although its decision was not explicitly linked to the practice, question marks were raised after the chief investment officer Hiro Mizuno’s recent comments. It was reported that he criticised the “short-termism” of short sellers, who borrow shares to sell, in the expectation that they can buy them back at a lower price, pocketing the difference.
“There is concern with many that the practice is unethical,” says James Hockley, partner at consultancy Sionic Global. “The questions beneficial owners often ask is whether they should go with the flow and not short or ignore the opportunity to take a bit of a return. I think instead they should look at how they can structure the trades and, for example, if there is a bond that is being held to maturity in their programme, it can be put out on an evergreen basis, which will optimise their position and returns without shorting.”
However, Dyson of ISLA has argued that in its simplest form, short selling is a platform for an investor to express sentiment either in a stock or an index, and as such may be no different to an index manager going over or underweight the index that they are tracking. He has said that there is now robust regulation, such as the EU rules on short selling, that has effectively curtailed or prohibited the use in an overly aggressive way by using techniques such as ‘naked’ short selling (short selling without borrowing the securities).
Other market participants also contend that short selling can facilitate price discovery, help expose poor behaviour by companies and create efficient markets. These views were reflected in the Alternative Investment Management Association (AIMA) Responsible Investment Primer published in May 2019. It stated that short selling is neither irresponsible nor unethical, and that it can form a critical tool in responsible investment.
According to the primer, “a manager could short a company with poor environmental practices that were hidden from the public and which the market had failed to price in”. However, AIMA did note that “some of the most stringent responsible investors may prohibit short selling for a variety of reasons”.
The ESG effect
Looking ahead, the way securities lending programmes incorporate ESG will continue to be a key theme reflecting the wider trends in the asset management industry. The Global Sustainable Investment Alliance’s latest report (‘Global Sustainable Investment Review 2018’), published in April 2019, revealed that global sustainable, responsible and impact (SRI) investment assets had risen 34% to $30.7 trillion since 2016. This varies markedly across the world, with Europe and the US leading the pack, having $14.1 trillion in assets under management and $12 trillion, respectively. Japan came in third with roughly $2.44 trillion divided between corporate engagement and shareholder action and ESG integration.
“ESG has definitely moved to the forefront of client conversations in recent months,” says Ross Bowman. global head of client management, securities lending at BNP Paribas, adding that historically conversations have tended to focus on the environment element but the subject has now widened to focus on the social and governance tenets in equal measure.
He adds. “A primary driver for this inclusivity can be traced to the discussions taking place in the asset management and the securities markets around responsible investing and good corporate governance; which is feeding through into securities lending programme discussions.”
The challenge for the securities lending industry is to move these discussions to the next level and ensure that best practices are being embedded into securities lending programmes. As Aviva’s Chadwick notes, “it is important to dispel any myths that securities lending is somehow incompatible with ESG and good stewardship. This is particularly significant given the importance of an orderly and efficient securities financing market as part of the broader sustainable capital markets agenda.”
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