3 things to know about lending shares

Investors can earn a significant premium lending out their portfolio holdings.

  • By Ellen Chang,
  • U.S. News & World Report
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Lending out shares to a broker can be an avenue for additional income.

Securities lending involves loaning a stock or other security like an exchange-traded fund to an investor or brokerage firm. Typically, share lending programs are operated by brokerages that lend securities out to traders who want to short stocks. Through lending shares, investors can participate passively by merely signing up for this option.

"On the face of it, securities lending can seem like an intricate practice, but once you understand the basics, your broker-dealer often takes care of the rest," says Chris Larkin, senior vice president at E-Trade, a New York-based brokerage company. "Putting your fully paid securities on loan may seem counterintuitive, but it's an often overlooked way for investors to help generate extra income from their portfolios."

Here are few aspects to consider when it comes to a stock loan:

  • Several brokerages offer securities lending programs.
  • High yields are possible.
  • Dividend payments are treated differently

Securities lending programs

Online brokers, such as E-Trade (ETFC), Interactive Brokers (IBKR), Fidelity and Charles Schwab (SCHW), offer this option. The fees are typically split equally with the broker.

The brokerages lend out the securities to third parties such as traders who want to sell short, says Andrew Wilkinson, chief market analyst at Interactive Brokers. Individual retirement accounts, or IRAs, are also eligible to participate in the stock lending program.

Lending stock to short sellers on Wall Street means that investors will receive "interest on the cash collateral posted to their accounts for the loan based on market rates," he says. Other brokerages pay a fixed rate for a fixed term.

"We split the fee received from lending stock 50-50 with the client," he says.

Lending and borrowing programs are an advantage for those who "may enhance the yield on the stock sitting idle in his or her account," Wilkinson says.

High yields are possible

What an investor earns in a return really depends on the stock and how much interest there is from Wall Street on shorting it. If the security being loaned is high in demand or hard to borrow, then the investor could yield a higher rate.

With this type of sale, short sellers borrow shares of a stock from a broker and sold. The short seller buys back the shares at a lower price in the future.

Short positions dampen the overconfidence of managers and optimistic shareholders, says Charles Trzcinka, a finance professor at Indiana University's Kelley School of Business.

"Tesla (TSLA) is one of the most shorted stocks on the planet," he says. "For every lover of Elon Musk, there is a skeptic. Investors who go short keep the market honest and capital allocation more efficient."

Shorts can cause volatility and possibly create a run downward on a stock, Trzcinka says.

"But negative information is as useful as positive," he says. "Short selling can have an unlimited loss, so investors will only hold short positions for a short time."

One potential hiccup is when investors own stocks that don't receive much interest from the market, such as thinly traded stocks, securities that are exchanged in low volumes and often have limited numbers of interested buyers and sellers. There are also no guarantees that the securities from their portfolios will get picked.

"It all goes back to the demand there is on the Street," Larkin says. "Like with any financial decision, read the fine print to understand the details of the program, the fees you may incur and potential tax implications."

Dividends are treated differently

One disadvantage is that dividend payments are treated differently when stock is loaned out. The lender will receive a payment from the borrower instead of the actual dividend, but that payment may be taxed at a higher rate than it would be if taxed at the normal rate of tax on dividends, he says.

"However, (Interactive Brokers) attempts to avoid loaning stock over dividend record dates," Wilkinson says. He adds that "clients may still sell their lend out stock at any time" and Interactive Brokers will recall lent shares.

Investors should also keep in mind that they can not choose the securities that are put up for collateral after enrollment start, but they have the right to sell the shares at any time.

The ability to receive extra income through share lending is a good idea, says CJ Brott, founder of Capital Ideas, a registered investment advisor in Dallas.

"With low interest rates being paid on credit balances, this looks like an idea that will spread," he says. "Sharing the short credit used to be between brokers and short sellers and was a big part of short sellers' profit cushion. It is usually a highly profitable source of income for brokers as it is relatively riskless."

Another catch is that the securities that have been loaned out are not protected by the Securities Investor Protection Corporation. The cash collateral received for the securities is typically protected by SIPC for up to $250,000 for investors, Larkin says.

He adds that brokerages' securities lending programs are an "automated way to help generate income in your portfolio, but make sure you understand the ins and outs before committing."

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