SAN FRANCISCO (MarketWatch) -- The hedge fund boom rarely presents new money-making opportunities for individual investors.
Now, however, increasing competition in one corner of the business is giving retail shareholders the chance to generate extra cash from the assets in their brokerage accounts.
Short selling, in which traders bet against stocks, has become more competitive in recent years as hedge fund assets soar and managers proliferate. Short sellers borrow a stock, betting its price will fall. When they return the shares to the lender at the original price, they profit from the difference.
'If there's a small available supply of stock to borrow, people will look for any new source.'
Joe Weinhoffer, Quadriserv Inc.
Usually, institutions with big, long-term stakes in companies earn interest in exchange for lending their stock to Wall Street firms. Those investment banks then lend the securities on again to short sellers at a higher rate. But with more hedge fund managers searching for profitable short trades, some stocks have become much more difficult to borrow.
The trend has encouraged brokerage firms to offer to pay retail investors to lend their shares too.
Charles Schwab (NYSE:SCHW) , the largest discount broker, runs a service in which it offers to pay customers interest on any loans of hard-to-borrow stocks from their brokerage accounts. The rate varies, depending on how much demand there is to borrow the stock.
Schwab rivals E-Trade Financial (NASDAQ:ETFC) and TD Ameritrade (NASDAQ:AMTD) say they too are considering similar services of their own.
"If there's a small available supply of stock to borrow, people will look for any new source," said Joe Weinhoffer, chief executive of Quadriserv Inc., a New York-based firm that specializes in helping hedge funds and other traders to borrow stock.
'Hard-to-resist'
Schwab, which launched its Securities Lending Fully Paid Program in 2004, markets the service to investors and financial advisers, summing it up in a brochure entitled "Hard-to-find stocks. Hard-to-resist opportunities."
The firm also draws up a list of dozens of hard-to-borrow stocks. A recent copy of the list obtained by MarketWatch contains 76 stocks.
Biotech and medical equipment companies including Dendreon Corp. (NASDAQ:DNDN) , Northfield Labs and Neurometrix Inc. (UTD:NURO) , are most heavily represented.
Homebuilders such as KB Home (NYSE:KBH) , Brookfield Homes and Dominion Homes are also on the list, along with mortgage lenders like IndyMac Bancorp , Delta Financial and American Home Mortgage .
Ethanol producers and other renewable energy and environmental companies like Xethanol Corp. , Medis Technologies (OTN:MDTL) and Trina Solar (NYSE:TSL) , also make an appearance.
Other big companies on the list include drinks giant Diageo (LSS:UK:DGE) , department store company J.C. Penny (NYSE:JCP) and luxury goods maker Gucci Group (OTN:GUCG) .
This type of service gives retail-focused brokers an entrée into the lucrative securities-lending business, said Joshua Galper, managing principal of Vodia Group, a financial-services consulting group that focuses on securities lending.
It's a business dominated by investment banks such as Goldman Sachs (NYSE:GS) , Morgan Stanley (NYSE:MS) and Bear Stearns . Wall Street firms generate more than $5 billion in annual revenue from providing so-called prime brokerage services, such as securities lending, to hedge funds.
Schwab's service targets wealthier customers who own a lot of shares in companies that are in demand among short sellers. It doesn't apply to stock held in a margin account.
"We're responding to demand in the marketplace and providing something that's appealing to some individual investors," said Glen Mathison, a Schwab spokesman. "As a result of growth in the number of hedge funds and the fact that most hedge funds employ some sort of short strategy, there's growing demand and a finite number of shares to borrow."
Lending Imergent
In one example from March 28, Schwab wrote to a customer who held 6,000 shares of Imergent Inc. , an online service provider that's battled accounting problems and is heavily shorted. The customer held the stock in a Roth conversion IRA account.
Schwab agreed to pay the customer an interest rate of 7% for lending the 6,000 Imergent shares, based on a share price of $19.34. The deal generated $677 a month for the customer, according to a copy of the letter sent by Schwab, which was obtained by MarketWatch. Imergent stock is up more than 10% since March 28.
If Schwab is willing to pay 7% to borrow a stock from its retail clients, the company is probably able to lend it back out at 9% or more, which illustrates the potential profitability of the business, Vodia's Galper said.
Developing such a service is very beneficial to brokers such as Schwab, because they can build up an ever larger network of wealthy clients to contact if they need to satisfy demand to borrow certain stocks in future, Quadriserv's Weinhoffer explained.
Weinhoffer joined Merrill Lynch in 1992 and helped develop one of the first third-party securities lending businesses. In 1993, he said he tried to develop a retail version, but "internal bureaucracy" got in the way.
"It was something that could be done from time to time, but to set up a system for it to work regularly was more difficult," Weinhoffer said.
Eric Hendrickson, a Merrill Lynch spokesman, declined to comment on whether the firm offers such a service to its retail clients now.
Retail stock lending programs are still a drop in the bucket compared to the institutional business, which accounts for most of the $717 billion of equities on loan in the U.S., Galper noted. Schwab's Mathison called its program a "niche service" for the firm.
Still, Galper suspects "everyone" will be offering the service within the next two years.
Extra income
While brokers make money on the transaction, Galper and others say it can still be an attractive way for individual, long-term investors to generate income from their stock holdings.
"It's an absolutely fair and justified thing to do and a fairly low-risk way of generating income" Galper said.
The main risk is that the broker could lend customers' stock to someone who defaults. That would leave retail investors fighting with the defaulted entity or their broker to get their shares back, he explained.
Schwab's Mathison said the program fully discloses the potential risks, lets customers get their stock back any time and ensures that positions are collateralized.
"We make sure people know how it works," he added. "Some people aren't comfortable with it."
Chris Cordaro, chief investment officer at Regent Atlantic Capital LLC, a wealth-management firm that oversees more than $1.5 billion for roughly 750 clients, said he's never come across such a service. But he said he's very interested.
"Why would I pass up a chance to generate more returns for clients from positions they're going to be in over the long term anyway?" Cordaro said.
"Hedge funds are going to sell it short, but who knows if they're going to be right?" he added. "In the meantime, my clients can get more income."
NovaStar stock loan
Stock lent by retail investors may well be borrowed by a hedge fund in a short sale. That could pressure the stock in the short term, and if the hedge fund manager's bet turns out to be correct, more losses could follow.
In a December article, Forbes magazine featured an individual investor called Roger Metzler who owned 32,000 shares of NovaStar Financial , a subprime mortgage originator that's heavily shorted.
By lending the stock out through his account with Smith Barney, the broker paid him a 13% interest rate. That generated income of $129,000 a year, according to Forbes.
However, NovaStar's shares have slumped so far in 2007 as a shakeout in the subprime mortgage market hit the company hard.
In mid-December, Metzler's 32,000 NovaStar shares were worth roughly $928,000. If the investor still holds the position, it's now worth $198,400. That $729,600 loss is more than the annual income he reportedly generated from lending the stock.
But for consultant Joshua Galper, situations like that merely highlight the usual market risk that investors take on when they buy stocks. Even retail investors who don't lend stock could see their company's shares shorted and falling, he noted, adding: "The real question is: are you maximizing the value of your assets?"
