Abstract
The dramatic increase in the percentage of mutual funds lending equities suggests that lending is an increasingly important source of income for investment advisors. However, borrowing demand for equities is a strong signal of future underperformance. We find that funds that lend equities underperform otherwise similar funds in spite of lending income. The adverse effect of equity lending is concentrated in funds that cannot act on the short-selling signal due to a fund family setting investment restrictions for a manager in order to diversify its portfolio of fund offerings across different investment objectives. When restrictions prevent a manager from selling a stock with strong borrowing demand, stock lending will at least generate some income that minimizes the effects of future stock underperformance.
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