Why the world’s biggest investor has called time on short selling

The world’s biggest pension fund has sent a shiver through the financial markets by stating it will cease lending shares to those seeking to profit from falling prices.

GPIF, the Japanese public pension fund, has a ¥80tn (£570bn, $733bn) portfolio.

The move affects the overseas part of it, which comes to $370bn, and it could have far reaching implications for the world’s stock exchanges if others follow suit.

The announcement drew an immediate response from no less than Elon Musk. “Bravo, right thing to do! Short selling should be illegal,” the Tesla founder tweeted, in response to the Financial Times posting the news.

I’m not sure Hiro Muzuno, the scheme’s chief investment officer, will necessarily welcome the support of Musk who has variously described shorters as “haters” and “jerks who want us to die”.

Its decision was reportedly taken only after considerable debate internally, and has landed the fund in the midst of a storm, which Musk’s involvement has exacerbated.

Short selling involves a market participant – typically a hedge fund – borrowing stock from an institutional investor to sell into the market in the hopes of buying it back at a lower price before returning it to its owner.

It’s a risky business to be in and it isn’t just Musk who doesn’t like it. Critics argue that shorting can spark or exacerbate market slumps, even recessions. Some have gone so far as to question the morality of profiting from falling prices, and regulators have been moved to limit – or even ban – the practice during periods of instability, such as the financial crisis.

Britain’s Financial Conduct Authority has the power to suspend or curb it in the event that a share – or other financial instrument – falls by more than a set amount under the Short Selling Regulation (SSR).

However, its defenders, and there are many, say it provides liquidity to the markets and helps people take a view on the pricing of securities. The revenues money managers get from charging fees for stock lending could also contribute to keeping their funds’ charges low.

Shorting activity can further serve as a useful early warning sign for when a company is in trouble. The sort of investors who play the game usually only act after having exhaustively analysed their targets’ financial health, performance, and prospects.

Even then they don’t always get it right. They concluded Tesla was overvalued at $50bn when Musk attacked them. For the record it’s now worth more than $60bn. So it’s Musk – who took their attentions far too personally – who’s smiling for now.

GPIF’s decision, however, is motivated by the importance it places on “stewardship”. The scheme demands that the fund managers it uses act to “enhance the long-term value of investee companies by conscientiously exercising voting rights for all the shares they hold”.

You can’t do that if you’re absent from the shareholder register through having lent your shares out. As GPIF says: “This effectively creates a gap in the period in which the stock is held by GPIF, and can be considered to be inconsistent with the fulfilment of the stewardship responsibilities of a long-term investor.”

It is possible to come to an arrangement whereby the lending investor gets the shares back for the purposes of voting at an AGM before they’re lent out again. But it doesn’t always happen and the sort of stewardship GPIF is advocating anyway calls for more than just voting at what are too often rubbing stamping exercises.

An interesting wrinkle to this has been unearthed by Pirc, the UK-voting adviser, and another advocate of big shareholders doing rather more than behaving as absentee landlords (as many still do).

Engagement is arguably at a premium when a company is in trouble. Yet Pirc has found that AGM turnout fell at companies like Thomas Cook and Interserve when they found themselves in choppy waters and were being actively shorted. Their shares being lent out for the purposes of shorting may explain why.

These companies mightn’t have got into such a pickle in the first place had their investors played a more active and engaged role.

Shorts aren’t the villains they are sometimes characterised as. But the focus by GPIF, which is also raised issues about the transparency of stock lending (who is the ultimate borrower?), on stewardship is commendable. It has raised a number of important points.

Its critics should also pay due heed to the fact that it has said it will revisit the decision if the issues it has raised can be addressed.