IS THE STOCK-LENDING BEHIND SHORT-SELLING COMPATIBLE WITH THE STEWARDSHIP CODE? WE THINK NOT
Short-selling has been in the headlines after retail investors ganged up to overwhelm hedge fund short positions in some selected stocks such as GameStop and Nokia. Apart from those invested in their strategies I doubt many will be weeping for the hedge funds. But it has been fascinating to watch from the outside and has led me to think again about the role of pension funds in this.
The likes of Melvin Capital have received a financial kicking but they have not yet lost the war. The stocks which retail investors have driven to nose-bleed-high price levels are even more attractive short targets, as their fundamental prospects have not changed. In principle we expect other short-sellers to come in, even if in the light of Melvin’s experience they will perhaps be more careful in how they manage their risk.
If that happens, the retail investors who piled in are going to lose their shirts unless they have the financial firepower to see off the hedgies again. Ultimately, this is not a battle they can win. Which leads to the fascinating question of whether or not the regulators should try in their own interest to stop them losing their money.
On the one hand this has the hallmark of a Ponzi scheme in that early investors can make money if they make an exit but those left holding the stock at the end will lose most or all of their investment. The difference is that there is no Madoff-like entity trying to benefit from it. If it were a promoter investing their own money and then encouraging others to follow regardless of value, we hope the regulator would step in sooner rather than later.
Against that are the arguments that stopping this trade is manipulating the market in the interests of the establishment – first and foremost the hedge funds who suffered. It does look like that in the short-term but, if we are right that actually the institutions - at least in aggregate - will win this war in the end, maybe the little guys do need to be protected from their own folly. And if there’s no single orchestrator the regulator can close down, then they have to look at other ways of doing so.
The bigger question, which is what I really want to come onto, is whether shorting is consistent with being a responsible investor. The argument for the practice is that it promotes price discovery and spotlights companies whose business models may not be sustainable. Think companies like Enron or Wirecard as two high profile examples which were exposed through shorting.
In a world of very low interest rates, zombie companies with little hope of long term survival can keep themselves going on the oxygen supply of cheap money. They are no longer forced into administration because their cashflow cannot support their debt, as used to happen. This process of destruction and renewal allowed the stronger to flourish to the benefit of society. Today low interest rates mean they can support large amounts of debt without going to the wall and other ways of exposing the weak – such as shorting - may therefore have more value than they used to.
On the other hand, there is no doubt that shorters throughout financial history have targeted weak holders as much as over-valued assets. Not infrequently this has led to viable companies being broken up or restructured not to the advantage of either their customer, employees or shareholders.
Pension funds and other investors who lend out stock bear some responsibility for the activities of short-sellers. It is of course very possible to take out a short position by using option strategies but most settlement of the initial trade is done by borrowing stock through stock-lending. On the other side of that trade are large investing institutions with long-term positions who take a fee for lending out their stock. Think passive managers and behind them pension funds in particular.
The 2020 Stewardship Code’s Principle Four enjoins signatories to ‘identify and respond to market-wide and systemic risks to promote a well-functioning financial system’ and among other things to report how they have aligned their investments accordingly. If the current imbroglio over shorting is not a systemic risk to a well-functioning market, it is hard to know what would count as one. In our view it is not possible for institutions to argue that they are fully aligned with this principle while they are facilitating shorting through stock-lending.
Principle Nine enjoins signatories to ‘engage with issuers to maintain or enhance the value of assets.’ Clearly engagement with a company will not stop its shares being shorted but it is harder to discuss other issues when the asset manager or investor is actively profiting from an activity in complete contradiction with this principle.
Which leads us finally to the role of passive investors. Stock-lending is one of the ways in which index managers keep the costs to investors low and, of course, passive investment is now a multi-trillion dollar industry. Despite our recent article on the conflict between passive and sustainable investment, we do believe that there is a place for passive investment within investment portfolios. The question is whether it can be done responsibly at today’s ultra-low fees?
We have questioned the practice of short-selling before with clients and at conferences. It seems to us that signatories to the new Stewardship Code need to think hard whether they can continue doing it. Even if that means passive managers charging a bit more.