Where should mutual funds invest their repo collateral?

May 31, 2009

Jason Zweig is the lastest person to decide that the financial sector should take less risk. After looking at mutual fund practices when it comes to securities lending, he concludes:

Your fund should lend out your securities, but the proceeds should go to you. And fund managers should reinvest the collateral only in absolutely safe securities. The current system, where they keep half the gains and stick you with all the risks, has got to go.

He’s right that funds should lend out securities, he’s right that the proceeds should go to investors, and he’s right that the current system is broken. He’s absolutely wrong, however, about the “absolutely safe securities”.

Investing in absolutely safe securities is something of an oxymoron: if they’re absolutely safe, it’s not really investing. Investing is meant to be the means by which capital gets allocated to where it can be most used efficiently. Securities lending is an important part of that process, since without it shorting stocks would be almost impossible, and as a result there would be less liquidity and the price discovery process would be damaged.

Mutual funds are also an important part of the capital-allocation process, since they’re actually paid to assess and take risks with investable capital. Consequently, it’s ridiculous that a mutual fund — pretty much the definition of an active risk-taker — should be shunning all conceivable risk when it comes to investing repo collateral.

The only “absolutely safe securities” are short-dated Treasury bills, and the last thing we need is an institutionalized flight to quality whereby every repo transaction involves an uptick in demand for short-term government debt. After all, we’re meant to be getting credit flowing again — and short-dated credit securities are far less risky than the equities in which most mutual funds are paid to invest. So let’s have mutual fund companies taking small and sensible risks with their repo collateral: it’ll be much better for all of us.


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