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BOSTON (Reuters) - 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 takeovers 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 U.S. 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 U.S. 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.
Even at firms that allow lending, some managers decline because they view it as helping hedge fund managers acting against the interests of long-term shareholders, said David Sackett, head of investment risk for T. Rowe Price Group Inc in Baltimore.
Others are eager to participate. "Some are long on a name and they don't mind lending it out for the short term because they have conviction," Sackett said. "And they can earn income while the hedge funds come and go."
About a year before Groupon Inc's November 4, 2011 IPO, Fidelity and American Funds invested $100 million and $175 million, respectively, in the company.
Once Groupon went public and its shares could be shorted, managers at American, which has about $900 billion in assets under management, never lent out stock of the world's largest online coupon website.
"We do not believe it is in our best interest to facilitate the short sale of stocks that we hold," American spokesman Chuck Freadhoff said. "We believe it puts downward pressure on the prices of stocks we're investing in for investors for the long term."
That concern is not universally shared. Securities lending rarely hurts mutual funds, said Washington University finance professor Matthew C. Ringgenberg, who has studied the issue.
"It's another way to beat competitors with smarter lending," he said. "They're better off doing it than not doing it."
At Fidelity, famed manager Will Danoff, who runs the massive Contrafund, had not loaned out shares of Groupon as of December 31, according to the fund's annual report.
But not long after the IPO, the Fidelity Blue Chip Growth Fund run by Sonu Kalra listed Groupon as one of about a dozen securities it had loaned out amid hot demand by short sellers, according to a report for the period that ended January 31.
Thanks partly to the short-seller demand for Groupon, the $13.7 billion fund generated about $1.2 million in securities lending fees during the six months ending January 31. Securities lending helped offset the fund's expenses by 2 percent during that period.
Kalra and Danoff appear to have different views on Groupon's long-term prospects, as well. Blue Chip Growth no longer listed Groupon in is portfolio at the end of February, while Contrafund held $186 million worth of the stock on the same date.
Groupon closed Wednesday at $13.08, or 35 percent below its IPO price of $20. Much of the decline followed its announcement that it would revise its fourth-quarter results, after failing to set enough money aside for customer returns.
Fund managers have long lent their stocks to short sellers to generate a modest, steady stream of additional income simply by re-investing the collateral they received. Income earned from investing the collateral offset a portion of fund expenses, increasing investor returns.
Since the peak of the financial crisis in 2008, however, many funds have overhauled their strategy from simply lending out stocks in large volume to emphasizing lending the most in-demand stocks -- those that stock-shorters have trouble borrowing.
As of April 10th, the value of stocks on loan worldwide totaled $761.4 billion, down from the peak level of $1.9 trillion in May 2008, according to Data Explorers.
Having huge amounts of collateral to invest proved risky as the collapse of brokerage firm Lehman Brothers taught funds that their cash could be tied up in murky assets. Demand for across-the-board borrowing has dropped as some big traders have reduced their leverage.
"Before the financial crisis, it was viewed as a costless exercise," said Robert Pozen, chairman emeritus at MFS Investment Management. "But the financial crisis drove home there are risks involved."
Dropping a volume-based program in favor of focusing on just hot stocks is more prudent and provides a better risk-reward trade-off, executives at Vanguard Group, which runs the world's largest family of mutual funds, concluded in a study last year.
"Lending scarce, high-demand securities results in a lower percentage of assets lent from a fund as well as a higher return per dollar of assets lent," Vanguard said in a 2011 report.
Reporting By Tim McLaughlin; editing by Aaron Pressman, Al Scott and Dan Grebler