Investing Insights: Apple Undervalued and Vanguard's 2018
On this week's episode, we examine Apple’s revenue warning, Procter & Gamble’s progress, top dividend picks and how Fidelity and Vanguard fared over the last year.
Editor's note: We are presenting Morningstar's Investing Insights podcast here. You can subscribe for free on iTunes.
This week on the podcast: Apple still looks undervalued; recapping Vanguard’s 2018; Procter & Gamble makes progress; 7 dividend picks; Fidelity’s 2018 winners and losers; and the impact of securities lending on investors.
Apple issued revised revenue guidance for its December quarter from $91 billion to $84 billion, which implies a 5% year-over-year decline.
The entirety of the shortfall was attributed to weaker iPhone demand in Greater China, while other regions and non-iPhone segments are faring better than expectations. In fact, non-iPhone segments combined to grow nearly 19% year-over-year
CEO Tim Cook pointed to a softer economic environment in China combined with rising trade tensions between China and the U.S. as key explanations, and we also sense Chinese nationalism in the form of shunning prominent U.S. products (such as the iPhone) played a major role.
Overall, we are maintaining our $200 fair value estimate, as cuts to our China iPhone forecasts are offset by stronger services and wearables expectations, and we see an adequate margin of safety as Apple’s growth trajectory lies with its ability to better monetize its installed base, rather than grow iPhone units in a largely saturated smartphone market.
Christine Benz: Hi, I'm Christine Benz from Morningstar.com. Has Vanguard been feeling competitive pressure in the wake of Fidelity's launch of free index funds? Joining me to discuss and other news at Vanguard over the past year is Alec Lucas, he's a senior analyst in Morningstar's manager research group.
Alec, thank you so much for being here.
Alec Lucas: Thanks for having me.
Benz: Alec, let's talk about the year very briefly before we get into some of the specific news items. It's been a tough year for both stock-pickers as well as bond-pickers.
Lucas: It's been pretty volatile, especially of late. We've had a correction early in the year and a near correction toward the end of the year.
Benz: In the equity market.
Lucas: In the equity market. Bonds, the agg is down about 1% year to date. The S&P 500's gained about 0.5 percentage point through roughly mid-December. So, a tough year but not a terribly year necessarily.
Benz: Let's get into the fund flows news at Vanguard. it seems like every time we've done these sit downs we've been talking about this Vanguard juggernaut, how they just are getting so many new inflows. It does seem that inflows have slowed a bit so far in 2018.
Lucas: They've slowed. Their strongest month was January, and if you recall January was a month where the market really shot up and investors were pouring money into it, at least into Vanguard so it seems.
Benz: It's often a good, I think a good month for asset managers in general.
Lucas: That too, for sure. There is lot of factors that figure into that. They continue to dominate in terms of flows nearly $140 billion in inflows. But that’s quite a bit less, they saw over $200 billion in inflows in 2017. This year they are on pace for roughly $166 billion if things stay where they've been; that's through October our data so far.
Benz: And the real strength in terms of flows, inflows that they have been getting have been mainly in the passively managed offerings, right?
Lucas: Yeah, it's interesting to just keep in mind that Vanguard coming out of the financial crisis was roughly half actively managed funds in terms of assets and half passive. It's now roughly 80% passive. They still have a very large actively managed business, but inflows have been predominantly in passive. You see that with their competitors; the next biggest recipient of inflows is iShares, their passive ETF products there. A secular shift away from active management continues.
Benz: Let's talk about Fidelity's launch of free index funds. How has Vanguard responded?
Lucas: Well, the phrase "turnabout is fair play" comes to mind. Vanguard's putting pressure on the industry for year's to lower fees, and now Fidelity has offered free index funds with no minimum investment. They debuted a couple in August and two more in September. In November, Vanguard announced that it was lowering the minimum investment for its admiral shares to $3,000, so that's lowering the cost of 38 index funds. That's been their competitive response.
There's a couple of caveats that are important. One is that this lowering does not apply to investors in their fund to funds. They won't benefit from the lower investment level and lower fees that come along with it.
To give context, the Vanguard Total Stock Market Index Fund now costs 4 basis points or 0.04%, but that's not free and you still have to have $3,000 minimum investment. Fidelity is offering a big challenge to Vanguard's hegemony, if you will, in indexing. But its important for investors to keep in mind that in opting for a free index fund, they maybe paying money elsewhere that they don't necessarily have to. For example Vanguard's money market funds offer a higher yield in general than Fidelity's. The two I compare there is 20 basis point differential.
Benz: And is that expenses mainly?
Lucas: I think that's mainly the fees. I didn't actually drill down to the fees, but my guess is that it is the fees.
Benz: Let's talk about another issue that has been top of mind for lot of Vanguard investors which has been some of the technology, the customer service. We have been hearing anecdotes from our users about this issue for the past couple of years. In part because flows have been so robust and so many investors have been gravitating to Vanguard there was an issue with some of the technology, though, this fall when we saw the market get rough.
Lucas: Oct. 10 the S&P 500 dropped 3.3%, its biggest drop in roughly eight months I believe, and a report came out in Financial Times that there were number of Vanguard clients who are unable to access their accounts. Obviously, it might be a time where you want to pour money in if you are trying to buy on the dip, and it can be very frustrating if you are not able to access your account.
Vanguard's experienced it's growth pains that it's had the past few years in terms of client service problems. In March of this year they announced a new client experience group, lab tests that they are doing. I think there is 12 lab tests that they were launching by the end of the year, that was the plan. They are planning to go global in 2019. They are very active in trying to address the client service problems, and I think its fair to say that any asset manager that's experienced the kind of growth they have would have probably similar struggles. I think they are spending as far as we can tell, through our report, that they are spending about 20% of their budget on technology and improving things. It's a substantial amount, I think things will improve there, but obviously they have a way to go.
Benz: Let's talk about performance, you put together a list of some of the best performing funds within the Vanguard lineup as well as some of the funds that haven’t performed so well relative to their category peers. One fund that looks really good, it's a closed fund, Vanguard Dividend Growth. Let's talk about what's going on there and why it has done pretty well in what has been a tough market.
Lucas: Its managed by Don Kilbride, and it's kind of fund it's really distinguished itself in falling markets. It tends to be very resilient. Dividend growth stocks in general have done well this year, but Vanguard Dividend Growth has done even better. It closed to new investors because he's had so much success, he invests in multinational companies that have shown commitment to growing their dividends. These are kind of companies, investors flock to when markets turn south. Its continued to do very well. Wellington, another Vanguard standard, has done very well and have been pretty resilient this year.
Benz: Both Gold-rated funds. U.S. Growth is another one that you pointed out. I am less familiar with this one. Let's talk about the story there.
Lucas: Kevin McDevitt covers Vanguard U.S. Growth, it's a multimanaged fund in terms of subadvisors. We have a Neutral rating right now, Kevin's concern was that it was a fund that had a pretty aggressive profile, but that seems to have worked well for it this year. It's doing quite well and very high up in its category.
Benz: Even though technology stocks and the high growth stocks have been ground zero of this recent market sell-off for the year, that's been a pretty good place to be.
Benz: Let's talk about the other side of the ledger some funds that haven't done as well. Vanguard Windsor and Selected Value, both value leaning portfolios. Let's talk about what's worked against them in 2018.
Lucas: Windsor bought GE earlier in the year, and obviously GE's had a lot of problems and its stock has continued to plummet. That's been a challenge for that fund. Selected Value to mid-cap value fund and small cap value stocks have really been the laggards this year in terms of thinking across the market. That's a headwind for that fund and they bought Adient I think a couple of years ago. Adient is a stock, that when I looked at it yesterday it was down 75% year to date roughly. It's a stock that’s been hit on, it had company-specific issues, but it's also been hit on trade concerns with China.
Benz: Selected Value though is still a fund that we like, it's just in the midst of a tough patch.
Lucas: It is, it had been a Gold-rated fund and we downgraded it I believe last year to Silver out of concerns that it would be probably more volatile going forward and at least that thesis has played out thus far.
Benz: Alec, I know a lot of our viewers are keenly attuned to the goings on at Vanguard. Thanks so much for being here to provide this recap.
Lucas: Thanks for having me.
Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.
Erin Lash: A year since its proxy battle with activist investor Nelson Peltz came to an end, P&G shares have trended higher, up at a mid-single-digit clip, outpacing the low-single-digit appreciation in the S&P 500 Index over the same horizon. However, we believe this reflects signs of progress after the prudent steps taken to steady its course over the last several years, as opposed to the oversight of one additional board member.
Although P&G has begun to deliver on its strategic agenda (with organic sales up 4% in the first quarter of fiscal 2019, in excess of the flat- to low-single-digit gains that have characterized the business of late), growth has yet to prove broad based. For one, beauty languished a few years back, but has since reversed course, stringing together mid- to high-single-digit top-line gains over the past six quarters, after parting ways with unprofitable products and launching fare centered on its core anti-aging messaging. We surmise its grooming business--which has posted low-single-digit declines on average since the fourth quarter of fiscal 2017--is also poised for more sustainable sales growth, although not to the same magnitude, as it implements a similar formula after succumbing to intense competition from lower-price upstarts.
In this vein, we'd suggest management's actions to recalibrate its pricing in the segment, invest in on-trend new products, launch its own subscription-based sales model, and drive trials by sending razors to 18-year-old U.S. males, mirror the wide range of endeavors P&G pursued as it worked to steady its footing in beauty.
However, we don't believe the path to sustainable top-line gains will prove linear. As such, we believe shares could retreat if sales falter in the near term, creating a more attractive entry point for shareholders. In the meantime, investors wanting to stock up on the household and personal care sector should look to wide-moat Colgate, in our view, which trades at around a 10% discount to our $70 fair value estimate.
Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar.com. As the year comes to a close, we thought it'd be a good time to pull together some of our best dividend-stock ideas from the past few months.
First we'll take a look at the yield-rich energy sector. Two of Morningstar's favorites in the sector, Enbridge and TransCanada, remain undervalued.
Joe Gemino: Some of our best energy dividend growth stocks are among some of our top calls in the sector.
Five-star rated wide-moat Enbridge offers 50% upside and also gives investors an attractive 6.3% yield. More impressively, we think that the company will meet its planned 10% annual dividend growth through 2020. Enbridge sports a near-term CAD 22 billion in commercially secured capital projects in its growth portfolio, which is highlighted by the Line 3 replacement project. We expect the growth portfolio to generate almost CAD 4 billion in incremental EBITDA, which will support the dividend growth with a healthy distributable cash flow ratio of 1.4 times the dividend, which is more than enough buffer.
If the stock price doesn't appreciate from current levels, we expect it to yield 7% at the end of 2019 and 7.7% at the end of 2020 when Enbridge increases its dividend each year.
Narrow-moat 4-star rated TransCanada offers 40% upside coupled with a 5.3% dividend yield. Like Enbridge, the company expects to grow its dividend, but in the 8% to 10% range throughout 2021. TransCanada boasts CAD 32 billion in commercially secured growth projects in its portfolio, highlighted by the Keystone XL.
If the stock price doesn't appreciate from current levels, we expect it to yield 5.9% at the end of 2019, 6.5% at the end of 2020, and 7.1% at the end of 2021 when TransCanada increases its dividend each year.
It's worth noting that the Keystone XL is not one of the projects that we expect to underpin near-term dividend growth. If the project is successfully placed into service, we could see further attractive dividend increases after 2021.
Dziubinski: Next up, the technology sector. This may not be the first place investors think of when it comes to finding dividend stocks. Yet there are some solid dividend payers among semiconductor stocks in particular. They include Intel, KLA Tencor, and Lam Research, which are undervalued today.
Brian Colello: There are three names with healthy dividends in technology that we'd like to highlight, all in the semiconductor space. They've been beaten down due to a near-term slowdown, but we think these are the times when it makes sense to buy moaty businesses that are poised to recover when the industry upturn begins. It may get worse before it gets better, but when the pickup in demand happens, it's often too late.
First is Intel. We have a $65 fair value estimate and see the stock as 25% undervalued. Intel has been beaten up due to a CEO transition and manufacturing delays, but we think it's a wide-moat firm that will ultimately recover from its missteps. The firm is still well-positioned, not only as the dominant PC processor supplier, but also the dominant server and data center chipmaker. With growing opportunities in automotive, artificial intelligence, and 5G, Intel is highly profitable and we think the dividend is safe.
Our other top two picks in tech are both in chip equipment, KLA Tencor and Lam Research. KLA has a wide moat with a 3.2% dividend yield. We have a $128 fair value estimate and see the stock as about 25% undervalued. Lam Research, narrow moat, positive moat trend with a 2.9% dividend yield. We have a $185 fair value estimate and see the stock as about 20% undervalued.
The story is similar for both firms: 2017 and early 2018 was a tremendous time for chip equipment spending as Samsung and other memory chipmakers expanded their capacity. There's now been a slowdown in spending on chip equipment. However, we think a recovery is in the works for 2019 and long term. There's ultimately few substitutes for the type of equipment that KLA and Lam provide to its customers.
KLA dominates in process diagnostic tools, helping customers improve their manufacturing yields. Lam Research is strong in etch and deposition, needed to carve out microscopic transistors inside of semiconductors. In both cases, we again think the dividend is safe and that management is committed to paying current payouts.
So for investors willing to weather the storm in the semiconductor space, we like Intel, we like KLA-Tencor, and we like Lam Research, not only for their nice dividends but also potential upside in the stock price.
Dziubinski: Finally, we'll consider a pair of stocks battling at the breakfast table: Kellogg and General Mills. Both dividend payers are inexpensive by our measures.
Erin Lash: While sales and consumption growth in the cereal aisle has languished over the past few years, we think investors would be well-served to indulge on the shares of the leading manufacturers in the space, namely wide-moat General Mills and Kellogg, both of which we view as undervalued.
For one, we think the market's confidence in General Mills' ability to restore top-line growth has faltered, considering continued softness in volume across the industry as well as skepticism around the acquisition of natural pet food company Blue Buffalo earlier this year. While the deal carries some inherent risk as General Mills enters a category in which it has limited experience, we remain confident in the firm's ability to efficiently integrate Blue Buffalo and extract cost synergies from combining these operations, as we expect it will lean on the experience gained when it added Annie's and others to its mix--leveraging its supply chain and distribution capabilities while largely leaving the acquired firm's operating model intact.
Further, we don't surmise its hunger for deals will compromise its ability to return cash to shareholders. We model a dividend payout ratio averaging 65% over our 10-year explicit forecast (which is in line with its five-year historical average), and implies mid-single-digit dividend growth. Given its discounted price, trading about 25% below our $58 fair value estimate, and with a 4%-plus dividend yield, we think the stock provides a sufficient margin of safety for long-term investors.
Further, we suggest investors with an appetite for income should give Kellogg a look, as it boasts a dividend yield of more than 3%. Kellogg's position as a leader in the U.S. cereal aisle (holding more than one third share of the domestic ready-to-eat cereal space), combined with its efforts to bolster its position in the on-trend snacking category (which now accounts for more than half of its total sales base, up from just one quarter at the start of the century) makes it a valued partner for retailers.
From our vantage point, Kellogg's decision to pivot away from direct-store distribution (which had accounted for about a quarter of its U.S. business) and transition completely to a warehouse model has been a prudent means to free up resources to invest further behind its brands in terms of innovation, marketing, and new packaging, and ultimately support its entrenched relationships with retailers, which we believe is a pillar of its intangible asset-based wide moat.
As such, with shares trading around a nearly a 15% discount to our valuation, combined with our expectations for mid-single-digit annual growth in its dividend over our explicit forecast horizon, we think investors would also be wise to keep this wide-moat name on their radar screens.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. After a strong 2017, some of Fidelity's largest funds are having a year to forget so far in 2018. Joining me to provide a recap of the past year at Fidelity is Robby Greengold. He is an analyst in Morningstar's manager research team.
Robby, thank you so much for being here.
Robby Greengold: It's my pleasure.
Benz: Robby, let's talk about performance across the Fidelity lineup starting with domestic equity. You averaged, or you took a look at all of the funds in aggregate and saw that the typical fund is underperforming its peer group so far in 2018. What's working against the firm's lineup?
Greengold: It's quite a reversal from last year. As you said, 2017 was really excellent, particularly for the large-growth space. But this year, through mid-December or so, about two thirds of the large-growth funds have been underperforming their category averages.
It's really due to the positioning from last year kind of carrying on this year, some of the large stakes that they've had. Some of their excellent stock-picking from last year, particularly in the technology and consumer spaces. Some of those names have rolled over. You think of a name like Facebook, Nvidia--those are names that are down roughly 20% this year through mid-December and that's had a big impact on some of the really big funds at Fidelity such as Fidelity Contrafund.
Benz: Let's talk about that one. That one is widely owned. I know a lot of our viewers pay attention to it because they own it. Some of the technology stocks I would assume those have been problem spots for the portfolio?
Greengold: A bit. The fund hasn't been a total disaster, Contrafund. It's just kind of middling this year. The really large stake in Facebook is a notable detractor. The fund continues to own it. Manager Will Danoff still continues to have conviction in the name, but it's hurt this year.
Benz: Growth Company kind of a similar story? I know that's always a very aggressively positioned fund. I am guessing the some of the same themes would hold there, but maybe even be amplified.
Greengold: Right. Yeah. Manager Steve Wymer, he did really well last year holding a big stake in Nvidia which did really well. But this year, as I say, it's come down and that's hit the fund a little bit. But we rate both funds Silver. It's pretty short period to be measuring them, but this year hasn't been so great.
Benz: Let's talk about Low-Priced Stock while we're on the topic of large funds. It's not a growth fund, but it too has not had its best year.
Greengold: Right. We've talked about some of these stocks that haven't been doing well, but still when you look at the market's performance, growth stocks still are in favor or they have been in 2018. That's not the focus of Low-Priced Stock. Joel Tillinghast, he's more of a value investor and his style has not worked well in this environment.
Benz: Certainly, the bifurcation between growth and value, when you look at the whole year, growth has really outperformed even though it's been lousy lately.
Greengold: One other thing is that Joel Tillinghast uniquely positions his portfolio with a relatively heavy stake in Japanese equities that's been a disadvantage this year.
Benz: Let's look at some of the allocation funds, these are the funds that blend stocks and bonds together. How are Fidelity funds doing relative to their peers within that category?
Greengold: It's kind of middle of the road. Doing a simple analysis, about half of the allocation funds are beating their category averages, half of them are underperforming. You look at a fund like the Fidelity Freedom Target-Date Series--that has not done particularly well this year. It's tough to point to a single detractor.
Benz: You think international overweighting there may have hurt a little bit.
Greengold: They had a relatively high stake in international stocks which have done relatively poorly when you compare that to the U.S. market. But then you have a fund like Fidelity Puritan which has done quite well in 2018, and that's because they have been overweight equities, relatively light stake in fixed income. It's now a Neutral-rated fund, previously Silver. But it's done well because of their positioning.
Benz: Let's take a look at fixed income. That marketplace, too, has been pretty tumultuous, it's been tough sledding for a lot of funds there. But the firm's funds, the firm's fixed-income funds are actually doing a little bit better relative to their peers.
Greengold: It's true. More often than not these fixed-income funds at Fidelity are holding up relatively well during a tough year for fixed income. We continue to like that team quite a bit.
Benz: You hinted at one of the downgrades. The Fidelity Puritan getting downgraded from Silver to Neutral. Let's talk about that, because you noted that performance has been quite strong.
Greengold: We thought very highly of the manager, Ramin Arani, who unfortunately isn't going to be with the fund anymore. His successor, Dan Kelley, he's a bit of an unknown. He has shown bouts of success managing some equity funds, such as Fidelity Trend, but this is kind of a new area for him. He hasn't managed an allocation fund before. Right now, our conviction needs to build in his ability to execute on this strategy. So, for now it's Neutral.
Benz: I remember Ramin Arani was around when I was an analyst. He's certainly been around the firm for a while. Fidelity Advisor Small Cap another fund that has received a downgrade to Neutral from Bronze. What's going on there.
Greengold: Its another manager departure that is a loss for sure. Jamie Harmon, who had been managing that fund for a long time, he'll be stepping off next year. His successor will be a manager named Jen Fo who doesn't have much of a management track record. She's been at Fidelity for quite a few years now, but mostly as an analyst. It remains to be seen where she takes that fund.
Benz: On the upgrade side of the ledger, Fidelity Small Cap Discovery was already a medalist, it was at Bronze, it's going to Silver. What do you and the team like there?
Greengold: Our confidence is building in that manager there, as it is at Fidelity International. Those are two funds that we've upgraded from Bronze to Silver. It's simply the result of us getting to know these managers better and our confidence in their skills, really just becoming bolstered there.
Benz: Let's talk about fund flows. Starting with active equity, it looks like Fidelity is still in redemption mode there.
Greengold: Continuous redemptions, particularly in the large cap equity space no surprises there, but that's not …
Benz: And not a problem exclusive to Fidelity by any means, it's really industry-wide.
Greengold: Right, right. Fidelity continues to experience heavy redemptions in their active space, their actively managed funds. They continue to gain share in the passively managed space. The Fidelity 500 Index fund which we rate Gold, for example, that continues to attract assets. Fidelity is pretty aggressive on pricing.
Benz: Well, certainly with the zero priced ETFs that it launched this summer, I mean that's the ultimate expression of that.
Greengold: Yes, in August they launched their first two zero expense index funds, and then they launched a couple of more in September. That approach has really just captivated the industry.
Benz: And driven prices down across the industry or helped drive prices down further. Robby thank you so much being here to provide this recap.
Greengold: Thank you Christine, I appreciate it.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Most investors don't realize that many mutual funds and exchange-traded funds loan out the securities in their portfolios. Joining me to discuss the practice of securities lending is Adam McCullough. He is an analyst in Morningstar's manager research group.
Adam, thank you so much for being here.
Adam McCullough: Thanks for having me today.
Benz: Adam, you authored a white paper that we published and linked to on Morningstar.com about the practice of securities lending. Let's just start by talking about what it is, because I think for many mutual fund investors and ETF investors, they may be quite unaware that this is going on at all. So, what's happening with securities lending?
McCullough: Absolutely. It is a backwater of finance in it is just, as it sounds, is the lending out of securities from a portfolio to borrowers who want to either borrow the stock to hedge, to short, or to take advantage of an arbitrage opportunity. And so, mutual funds and ETFs, particularly those that track broad indexes, are natural lenders of securities because they have such a broad array of securities, and they are passively owned. So, they are not going to be buying and selling these securities.
What these funds can do is they can lend out those securities to borrowers that want to short sell them or do other things with them and earn income on those that can help offset their fee, and in some cases, that offset can be meaningful and offset a majority of the fee that you would pay as an investor in that fund.
Benz: That's one of the benefits, which I want to get to. But before we get to that, I think, some people may have become aware of securities lending during the financial crisis where you had some funds run into trouble with the practice. Let's talk about how the risks can come home roost in some cases.
McCullough: Absolutely. So, securities lending did earn a checkered reputation during the financial crisis. Most of those losses though were from pension and endowment funds. Our focus here is more on the mutual fund and ETF side, which are governed by the SEC under the 1940 Act. The restrictions on how you reinvest the collateral that the borrowers post when you lend out the securities is much more stringent …
Benz: So, the fund company takes in the borrowers' assets, loans them the securities and so, the borrower has to give you some collateral. That's what you are reinvesting to earn an income stream. That was the problem spot?
McCullough: That was the problem spot. So, just to back up, there's two risks. When I lend out a security--let's say that you are lending me a security, the risk is, one, that I'll default on that security. I won't return it back to you.
Benz: That would be bad.
McCullough: That would be bad. In the U.S., what has to happen is, I have to post collateral to you as you lend out the stocks. Say you lend out $100 of Tesla stock to me, I post to you usually cash collateral to the tune of $102 per $100 of stock that you lend me.
Benz: I get to invest that?
McCullough: Then you take that, and you can invest that to earn additional income on the cash that I post to you as collateral for the lent security. As a lender of securities you stand to earn, one, the lending fees--so that's you lend the stock, there's a fee associated with that based on supply and demand--and you also earn the income from reinvesting the cash collateral.
During the financial crisis, what we saw was there were losses from the cash collateral being reinvested too aggressively and seeing losses from that reinvestment rather than the default risk associated with lending me that security because the collateral could usually cover the losses of any defaults.
Benz: So, you say though mutual funds, because they are better regulated than perhaps some of these other institutional entities that you think there's less of a risk for them?
McCullough: I would say, even more so today there's even less of a risk because the SEC has upped the quality, the liquidity, and the duration standards of the cash requirements the collateral has to be invested in. So, the risk today is even smaller. And I think just from the nature of this all happening during the crisis is that there's response from regulators, there's more transparency into the practice and people know now that this is a risk that can happen. And so how we always fight the last war, I think now this has been an issue that's been addressed, and it won't be as big of an issue going forward. So, the risk is smaller today, but the benefit is still there for mutual funds and ETF investors.
Benz: Let's talk about that benefit. It sounds like it would read down to me as an investor not just to the fund company, right? So, it's not necessarily the fund company's profits but I as an investor may benefit from the practice of securities lending?
McCullough: Right. Absolutely. What usually happens is, is the fund company will have a lending agent that goes out and finds borrowers so that this fund company can lend its securities to those borrowers. This agent as a part of its payment takes a cut of the fee that is generated from lending out these securities.
In most cases, in the U.S., for passive fund sponsors, they use a third-party agent. Think of the big custodial banks like Bank of New York Mellon, Northern Trust, State Street. It's a handful that use their own lending agent, think of BlackRock, Vanguard, Fidelity on its bond side. So, in those cases, the fund company will be earning that cut of the revenue that it generates from securities lending. It's the third party affiliated of the fund company. So, it is at arm's length, but most of the income from securities lending is passed back to the fundholder and is seen on the annual report of the fund as securities lending income. So, usually, we see 70%-plus of that passed back to the fundholder.
Benz: You unpacked fund family by fund family in your research which fund companies tend to do a better job of sharing some of those revenues with fundholders to lower expense ratios.
McCullough: That's right. It's interesting. Of the three fund companies that manage their own programs, BlackRock actually takes the most of the sec lending revenues. So, it's taking 30% from U.S. equity funds of the gross securities lending revenue and passing along to fundholders 70% of that. Fidelity also manages its own program on the bond side, and it passes along 100% of the securities lending revenue to its bond fundholders. State Street is right in the middle. So, it charges 15% of the gross securities lending income as a part of its fee for providing these services and matching borrowers and lenders of securities. For the rest of the fund companies that use independent third-party securities lending agents, the split is between usually 20% and 10% of the gross securities lending income generated for the fund.
Benz: That percentage goes to the fund company?
McCullough: It goes to the securities lending agent. So, then you'd have 80% to 90% of their revenue is passed back to the fund and fundholders.
Benz: Got it. So, say, I hold an index mutual fund and I want to do my homework on, well, what are the practices going on here in terms of securities lending if I want to do my due diligence. How would you suggest investors go about that?
McCullough: There's three things I think to be aware of. The first one, as we just mentioned is, what is the fee split. That's going to be consistent through time. It's like if you invest in a fund and it's cheap, that's going to be a persistent edge you have by investing in a cheap fund.
Benz: And that's documented, right, in my shareholder literature, what that percentage is?
McCullough: Exactly. So, it's actually broken out in the statement of additional information where it goes from gross securities lending income to net securities lending income. It provides a line item by line item basis of what you are paying for that revenue generated. That's the first thing is the fee split. The second thing is the benefit of the income to the fund. So, usually small-cap funds can generate more securities lending income because they hold securities that are hard to find in the market.
Benz: So, they can charge a premium for lending?
McCullough: Exactly. So, all the lending fees are based on supply and demand in the market. So, it's usually harder to find small-cap names just based on the supply issue. On average, small cap stocks command a higher lending premium than large-cap stocks. Usually, small-cap funds will be able to offset more of their fee with securities lending revenue than large-cap stocks. Looking forward, the historical offset or the revenue pass-through is a good indicator of it might be in the future, but it's not always consistent.
Benz: Is this something that you and the team write about or plan to write about in your research reports of actual individual funds?
McCullough: We do cover it in our research reports. We usually look at the tracking difference between an index mutual fund and an ETF and its fee. And so, usually, if the fund is able to track the index by an amount that's less than its fee drag--so, say, that a fee charges 20 basis points over the course of a year, if the fund is able to track that index by an amount less than 20 basis points, then that's usually an indication that it's using securities lending income to offset that fee drag. And that is something that we do write about. Also, going forward, I think that Morningstar is looking into collecting these data points for our products as well.
Benz: Adam, really interesting research. Thank you so much for being here to share it with us.
McCullough: Thanks for having me today, Christine.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.