It’s in the air again, on Reddit, in Congress, in the C-suite: Hedge funds that get rich off short-selling are the enemy. The odd thing is, the biggest players in the game are getting a pass.
Those would be the asset managers, pension plans and sovereign wealth funds that provide the vast majority of securities used to take bearish positions. Without the likes of BlackRock Inc. and State Street Corp., the California Public Employees’ Retirement System and the Kuwait Investment Authority filling such an elemental role, investors such as Gabe Plotkin, whose Melvin Capital Management became a piñata for day traders in the GameStop Corp. saga, wouldn’t have shares to sell short.
“Anytime we short a stock, we locate a borrow,” Plotkin said Feb. 18 at the House Financial Services Committee hearing on the GameStop short squeeze.
There’s plenty to choose from. As of mid-2020, some $24 trillion of stocks and bonds were available for such borrowing, with $1.2 trillion in shares—equal to a third of all hedge-fund assets—actually out on loan, according to the International Securities Lending Association.
It’s a situation that on the surface defies logic. Given the popular belief that short sellers create unjustified losses in some stocks, why would shareholders want to supply the ammunition for attacks against their investments? The explanation is fairly straight forward: By loaning out securities for a small fee plus interest, they can generate extra income that boosts returns. That’s key in an industry where fund managers are paid to beat benchmarks and especially valuable in a world of low yields.
The trade-off is simple: For investors with large, diversified portfolios, a single stock plummeting under the weight of a short-selling campaign has little impact over the long run. And in the nearer term, the greater the number of aggregate bets against a stock—the so-called short interest—the higher the fee a lender can charge.
In the case of GameStop, short interest was unusually high and shares on loan were generating an annualized return of 25% to 30%, Ken Griffin testified at the Feb. 18 hearing. Griffin operates a market maker, Citadel Securities, as well as Citadel, one of the world’s largest hedge funds.
“Securities lending is a way for long holders to generate additional alpha,” said Nancy Allen of DataLend, which compiles data on securities financing. “Originally, it was a way to cover costs, but over the last 10 to 15 years it’s become an investment function.”
Not everyone is comfortable with the inherent conflict. In December 2019, Japan’s $1.6 trillion Government Pension Investment Fund stopped lending its international stock holdings to short sellers, calling the practice inconsistent with its responsibilities as a fiduciary. At the time, the decision cost GPIF about $100 million a year in lost revenue.
The U.S. Securities and Exchange Commission has regulated short-selling since the 1930s and polices the market for abuses such as naked shorting, which involves taking a short position without borrowing shares. Proponents of legal shorting argue that its use enhances liquidity, improves pricing and serves a critical role as a bulwark against fraud and hype.