A string of frothy initial public offerings gave a surprise boost to some of their mutual fund shareholders in the first quarter. Some funds that bought into hot IPOs, like Zynga and Groupon, are boosting their returns by lending the shares to short sellers. Not all funds engage in such lending, with some arguing that it aids their mortal enemies, but for those who do, the profits can add up.
Mutual funds lending stocks in high demand to short sellers earn extra fees, called a scarcity premium, that can be 20 or more times higher than what they command from lending widely available stocks. At one point during the first quarter, fees on Zynga jumped off the charts - equivalent to an annual lending rate of 51 percent of the value of the borrowed shares.
Such circumstances arise when demand for borrowed shares from hedge funds, arbitrageurs and Wall Street firms vastly outstrips the available supply. It presents a particular problem with stocks that just went public, without many shares trading yet. The extra fees can range from a few hundred basis points to thousands of basis points. In 2012, the hardest to get stocks besides Zynga and Groupon have included Kinder Morgan Inc, Sears Holding Corp , Tesla Motors Inc and ITT Educational Services Inc, according to Data Explorers, a securities finance research firm.
Demand for shares of much-hyped initial public offerings and companies involved in take-overs has been close to insatiable, according to CIBC Mellon analyst Jeffrey Alexander. In addition to game developer Zynga, top "specials" in the first quarter were casino operator Caesars Entertainment and Groupon, Alexander said.
More than 6,000 US stocks are subject to lending, but the hardest-to-get 100 generate 43 percent of overall revenue, up from 28 percent in March 2007, New York and London-based Data Explorers said.
Those stocks have become the focus of mutual funds willing to lend. "In the US market, there's a much greater emphasis on the biggest bang for the buck," said Tim Smith, executive vice president at Sungard Astec Analytics in New York.
However, the major fund firms have radically different policies on lending shares to shorters in exchange for fees and extra income, with a small portion sometimes going to outside or internal lending agents.
Fidelity Investments and T. Rowe Price, for example, let their managers decide whether to lend shares, and many do lend out their funds' holdings. American Funds decries the practice as aiding the enemy and bans lending.