09/25/07 Do Retail Investors Hold The Aces? -Forbes

Do Retail Investors Hold The Aces?


Financial Services
Do Retail Investors Hold The Aces?
Liz Moyer, 09.25.07, 4:40 PM ET

Retail investors wield more power than they think when it comes to short-sellers.

With $3.6 trillion worth of stock held in their non-margin accounts, brokerage customers are viewed to be the next big Gold Rush for Wall Street traders. That's because that stock has the potential to be lent out to short- sellers for a fee, and increasingly it's the retail customer getting a cut of the profits.

A report by New York-based Vodia Group says retail brokerage customers have the potential to shake up the securities lending market, estimated at $4.8 trillion globally, of that $717 billion of stock lent out in the U.S. at any one moment.

Retail investors have $9 trillion of assets in their accounts, a little over one-third in stocks and the rest in other assets. Institutions, such as pension funds, have $26 trillion of available assets, one-quarter of that stock.

Securities lending reaps $8 billion to $10 billion annually in fees for Wall Street, but is a business largely unknown to the general public.

Still, some retail investors are getting savvy and asking questions. Since Forbes first wrote about this phenomenon in December; Merrill Lynch and Fidelity Brokerage have joined Smith Barney and Charles Schwab in establishing stock lending programs for retail customers, according to Vodia Group.

There are a number of caveats with these programs, mostly qualification requirements, and the brokerage industry has to do a fair amount of education to get retail customers past their natural wariness of short-sellers. But, writes Vodia's managing principal Josh Galper, "this investor is looking, cautiously, at securities lending to generate additional portfolio returns while minimizing risk."

Participation in a stock loan program requires a bit of cynicism on the part of the individual investor. Presumably, that investor holds a stock hoping it will go up. Lending those shares to a short-seller has the potential to drive the price of the asset down (that's the short-seller's raison d'etre, after all). But if the stock is in hot enough demand, the fee to lend it may more than compensate for the decline in the share price, plus the temporary loss of voting and dividend rights. It's sort of like an insurance policy in case your long strategy proves erroneous.

It's important to note this is about so called fully paid accounts, not margin accounts, which have always been available to brokerages for the purpose of lending stock to short-sellers. With margin accounts, the retail customer (the owner of the stock) doesn't get a cut of the lending fee. In these fully-paid account programs, the customer gets a piece of the pie.

It's also potentially good for short-sellers, who are scrambling for access to stock. Short-sellers borrow shares and sell them, hoping the stock will fall and they can buy it back later at a discount, cover the loan and keep the difference. The hotter the demand for a particular stock to borrow, the harder, and more expensive, it gets to borrow.

So it goes without saying that a larger pool of available stock inventory, particularly for the hardest to borrow stocks, would lower the costs of business for short-sellers.

Short interest is at near record levels, an indication that traders are certainly hungry for more stock to borrow. At the NYSE Group, short positions in the most recent month represented 11.8 billion shares. That's down from the peak of 12.9 billion shares in July but certainly well above the 9.7 billion shares logged last year around this time.

The popularity of so-called 130/30 mutual funds is in part driving this demand. These funds use leverage to take on long positions of 130% of the portfolio and short positions of 30%, the theory being everything nets to 100% at the end of the day.

The funds mimic hedge funds in many ways, but with lower fees, and are attracting billions from pensions and other institutions chasing the new, new thing. High profile managers are jumping in, includingBarclays, State Street, and Goldman Sachs. There are an estimated $50 billion to $75 billion of assets in 130/30 funds now.

Hard to borrow securities held by retail brokers is estimated at $146 billion, which would add another 20% to the inventory available to short-sellers in the most in-demand stocks. That's where the individual investors come in.

If enough retail investors make enough money lending their shares out, who knows? Maybe hedge funds won't be viewed as such bad guys after all, says Galper. Investors "will gain more comfort with securities lending as a revenue generator, leading to perhaps a warmer popular sentiment towards hedge funds as legitimate market actors," he says.

That is, until the next big blow up.