Distortions Caused by Lending Fee Retention

Some mutual funds retain a fraction of securities lending income by employing in-house lending agents. In a model with heterogeneous investors and endogenous delegation to mutual funds, we show that a subset of funds optimally engages in lending fee retention and as a result, overweights high lending fee stocks that endogenously underperform. We find empirical evidence consistent with our model’s predictions; active mutual funds we identify as fee retainers invest more in high-fee stocks and underperform relative to both nonretaining and nonlending funds. We also show that fee retention helps explain the negative relation between lending fees and future fee-inclusive stock returns. This paper was accepted by Lukas Schmid, finance. Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2021.01390 .