Why sustainable investors should embrace shorting
Shorting should be part of a sustainable investor’s toolkit; Planet Tracker views this as compatible with ESG investing although some may disagree. It allows for a more efficient market and can be used to manage risks. Perhaps more importantly it allows investors to precisely align their investments with their beliefs and call out players which overstate their investment credentials – i.e., partake in greenwashing. The more that investors are able to redirect capital flows to sustainable companies, the better. We anticipate the emergence of more complex sustainable investing strategies which are likely to involve both shorting and leverage, with one caution – this should be left in the hands of investment professionals as losses can be unlimited.
What is shorting?
Shorting is also known as short selling. It is an investment strategy adopted by an investor who believes a share price will fall. The investor borrows some shares[1], and immediately sells them in the market. The investor is hoping to buy them back at a lower price at a later date and return the shares to the lender, which earns a fee for the lending, and keep the price differential – i.e., the price at which they were sold versus the price they were bought back. This is the opposite of buying shares and holding them in the hope they will rise. This is known as going ‘long’. Shorting can involve physical short selling, but one can also obtain synthetic short exposure through the use of derivatives or other financial instruments. Shorting is often a short-term investment strategy so that additional expenses such as borrowing costs are minimised.
Is shorting responsible?
It depends upon who you ask.
Planet Tracker does not view the use of shorting as an ESG or sustainable[2] matter per se. It is simply a contract between two investors with the seller of the shares believing that the share price will fall in a timely manner. The lender of the shares, which the shorter requires to undertake this contract, earns a fee for their investors. This practice does not undermine the health of a company in the same way that buying a company’s shares does not improve its underlying fundamentals.
Supporters of shorting argue that it leads to a more efficient market where misinformation and mispricing can be rectified promptly. It leads to price discovery as the short seller may declare their reasons for shorting – e.g., because they are questioning the company’s accounts or statements from management.
There are also other perceived benefits. The Technical Committee of the International Organization of Securities Commissions (IOSCO) argued in 2009 that it believed that short selling plays an important role in the market for a variety of reasons, in addition to price efficiency, by ‘mitigating market bubbles, increasing market liquidity, facilitating hedging and other risk management activities’.[3]
The recent ‘meme stocks’ volatility – notably GameStop [GME US] and AMC Entertainment [AMC US] – raises a larger issue of whether the disgruntled retail investor can take on the more powerful institutional managers. If Main Street is dissatisfied with Wall Street’s choice of investments, particularly on ESG issues (see Online Retail Investors: Can’t see the wood for the trees!) why shouldn’t they take on the asset managers at their own game? However, it’s important to emphasise that these trading strategies are only for highly skilled investors who fully understand the risks.
On a more technical point it is worth noting that shorting strategies can be useful when attempting to implement tax efficient strategies. In a research paper[4] AQR, a global investment management company, points out that short positions allow investors to benefit from the anticipated underperformance of securities and can create tax benefits because they enhance opportunities to time capital gains realizations. In other words, ‘a portfolio’s long positions tend to realize net long-term capital gains taxed at relatively low rates, whereas short positions tend to realize net short-term capital losses, which can offset short-term capital gains from other strategies in the investor’s portfolio’.
Despite these benefits, some ethical investors disapprove of short sellers terming them ‘bank robbers and asset strippers’.[5] This is founded on the view that shorting makes exposed corporates even more vulnerable; it seeks to make a profit on the back of another’s weakness. Some experienced investors support this view. In 2019, Japan’s Government Pension Investment Fund (GPIF), the world’s largest pension fund, stopped stock lending for short selling, calling the practice inconsistent with its responsibilities as a long-term investor[6] with its CIO arguing that ‘I never met a short seller who has a long-term perspective’.[7]
Other investment firms such as Baillie Gifford have also agreed, but not for all its funds. Schroders believes that ‘some short sellers are unethical but short selling itself is not’. The company is critical of some of ‘the more extreme activist shorters … that give the practice a bad name. Some have been guilty of spreading unfounded and malicious rumours…even if these companies manage to prove the accusations false, the short seller may be long gone by that stage, having booked a profit on their trade and left a trail of devastation in their wake’.[8]
Furthermore, shorting is viewed as a particularly dangerous type of investing. When investors buy shares in a company, they hope they will rise. The maximum loss on this investment is 100% – i.e., everything if the company goes bankrupt, for example. But if you take a short position there is no limit to the loss you can make if the shares rise. This might happen if there is a takeover bid, for example. In this instance, the short seller will try and buy back the stock as quickly as possible and return the shares promptly to the lender. There are further costs that need to be considered such as commissions and possibly dividend payments.
From time-to-time market regulators can become nervous about short selling largely because of the risk that it can exacerbate disorderly markets especially in extreme market conditions. In the 2008 financial crisis a number of regulators placed temporary bans on short selling. Most of these bans had been lifted by May 2009 although different levels of disclosure were still applied by exchanges.[9]
The value of shorting to sustainable investors
ESG and sustainable investing is often viewed as a long term and long-only strategy. Investors buy and hold the shares and focus heavily on engagement. Let us consider the aims of sustainable investors:
- Invest in line with ethical beliefs – e.g., companies with a clear biodiversity or carbon neutral strategy
- Minimise undesired investment risks – e.g., avoid manufacturers of single-use plastics
- Encourage the flow of capital to particular industries – e.g., into renewable energy companies
- Generate better investment performance – i.e., demonstrate ESG screening provides superior returns
The issue is whether short selling can help achieve these aims. We believe it can.
There is certainly support for the idea that short sellers which detect fraud and poor governance ‘have contributed to advancing the ‘G’ component in ESG thinking on the global sustainable finance market’.[10] Analysis by Lou and Karpoff in The Journal of Finance, argued that ‘short sellers anticipate the eventual discovery and severity of financial misconduct. They also convey external benefits, helping to uncover misconduct and keeping prices closer to fundamental values’.[11] The Global Principles for Sustainable Securities Lending, which is creating an ESG standard for owners, lender, borrowers and impact creators globally, recognises ‘that short selling forms part of broader long-short strategies and enables market participants to express contrarian views that benefit long holders through a more thorough analysis of risk’.[12]
In reality, many ESG active funds and ETFs are in effect shorting (selling) stocks – i.e., the investor hopes to profit from a drop or underperformance in the stock price. Although these funds are not borrowing stock to undertake a short position, they will underweight particular sectors and companies relative to their performance benchmark. By making this decision not to purchase the stock – i.e., have no investment holding in this company or to hold a smaller position than the fund’s performance benchmark – the portfolio manager is forecasting the stock will underperform the index. For the passive investor, they can simply choose a sustainable index which excludes the poor ESG constituents, as long as it’s aligned with their beliefs. The development of direct indexing is allowing sustainable investors to choose a portfolio exactly in line with their aims. For a fuller discussion please see ‘Indexing: Prepare for Sustainability-Driven Disruption’.
The same will be true for lower carbon funds. These funds will aim to reduce the carbon footprint of the portfolio by excluding (not buying) or underweighting (buying less of the stock than the index weighting) of the highest carbon emitters. Although strictly not shorting – as there is no borrowing and subsequent return of the shares – it does require an investment decision not to own or to underweight the security when compared to the fund’s performance benchmark.
If we examine carbon footprints, a paper by AIMA and Simmons & Simmons – ‘Short Selling and Responsible Investment’[13] demonstrates the value of shorting to reduce carbon risks. Should a carbon tax be implemented, carbon intensive companies would likely incur share price declines. If these companies were shorted, the portfolio manager would profit from this decline providing positive returns for the fund’s investors. In this instance the benefits to the portfolio are clear. However, if enough market participants adopted such a strategy, ‘it could increase the cost of capital for the targeted issuer, thus incentivising that issuer to protect itself against carbon risks by actively transitioning its business model to be less carbon-intensive’.[14]
One of the livelier discussions in the sustainable/ESG arena is over divestment. Often sustainable investors are caught between a rock and a hard place. If they are owners of a stock that is perceived as a poor ESG performer – e.g., an oil & gas explorer and producer – they will be criticised. However, a holding in the company allows the investor to engage with management and encourage the implementation of a transition strategy or the divestment of certain assets. The recent announcement of the sale of BHP’s oil & gas assets may be a case in point.[15] On the other hand, once the sustainable investor divests, the ability of the investor to influence management becomes difficult. There is also the option for the investor to adopt a more aggressive investment programme by using a short-selling strategy.
At present, shorting is an unusual investment strategy for ESG investors, but one that the hedge fund AQR Capital Management has advocated to the Australian Prudential and Regulatory Authority (APRA). It is reported to have argued that ‘“The usual approach of security selection (e.g., divesting from firms with the highest emissions) can lead to a substantial carbon reduction but may not be enough for investors with the most ambitious reduction targets… Such investors may need other techniques to achieve their goals, for example shorting high carbon-footprint companies or trading instruments such as carbon offsets and carbon permits’.[16] Since, AQR has commented further on the importance of shorting arguing ‘the proper treatment of shorting matters for the ultimate goal of responsible investing: to effect change’.[17]
When comparing the impact of investing and holding a position in a company against shorting the stock, AQR provide a useful assessment. ‘Impact is never easy, but the most realistic case by far for affecting the real economy is holding a large position in an issuer, voting shares, engaging, and maybe even getting a seat on the board. None of this will happen if the investor takes no position in the company. But you can have some impact when you short a company – not as much as a long investor, but more than a non-investor (and, of course, adding shorting doesn’t detract from your ability to impact through your long positions).’[18]
Other commentators have argued that sustainable investors should examine long-short strategies.[19] AFII Research’s recent paper proposes that by using leverage in the form of long-short strategies, ‘the investor can reduce or even make their footprint negative when their investment allocations drive (shifts of) cost-of-capital and full economy emissions reductions’.[20] Furthermore, the analysis looks at debt instruments arguing that because ‘debt has a direct link to the cost-of-capital of the companies’, this asset class is of particular significance.
With the growth of investment flows into ESG and sustainable investments, it is unsurprising that some hedge funds are rumoured to be examining such investments for pricing inefficiencies or management teams playing up their sustainable credentials.[21] It was partly down to the perseverance of short sellers that accounting fraud was eventually exposed at Wirecard (WDI GR).[22] Last year Loop Industries (LLPP US) came under attack from short sellers which claimed that their PET recycling technology ‘is smoke and mirrors with no viable technology’.[23] We encourage close scrutiny of corporate ESG claims which may expose inaccurate management announcements.
A case study: Nikola (NASDAQ: NKLA) – shorting a sustainable stock
Nikola is a designer and manufacturer of zero-emission battery-electric and hydrogen-electric vehicles, electric vehicle drivetrains, vehicle components, energy storage systems, and hydrogen station infrastructure.[1] It was founded in 2015 in Salt Lake City, Utah.
March 2020 – Nikola announced plans to merge with VectoIQ Acquisition Corporation (VTIQ) a publicly traded special purpose acquisition company (SPAC) run by a former General Motors (GM US) vice-chairman.
June 2020 – Nikola’s stock began trading a day after the merger was completed. Over the course of several private offerings, and then in connection with a business combination with a SPAC, Nikola raised more than $1 billion dollars, most of it from institutional investors.[1] After entering into a business combination with the SPAC, Nikola began trading on the Nasdaq.
September 2020 – Hindenburg Research issued a report claiming Nikola is ‘an intricate fraud built on dozens of lies over the course of its Founder and Executive Chairman Trevor Milton’s career’. The disclosure on the research report stated, ‘After extensive research, we have taken a short position in shares of Nikola Corp. This report represents our opinion, and we encourage every reader to do their own due diligence’.[1]
September 2020 – Nikola released a statement: ‘Yesterday, an activist short-seller whose motivation is to manipulate the market and profit from a manufactured decline in our stock price published a so-called “report” replete with misleading information and salacious accusations directed at our founder and executive chairman. To be clear, this was not a research report and it is not accurate. This was a hit job for short sale profit driven by greed’.[1]
September 2020 – Nikola and General Motors (GM US) form a strategic partnership[1]
September 2020 – The US Department of Justice reported to be making inquiries into claims levelled against Nikola in a short seller’s report.[1]
September 2020 – SEC reported to be examining Nikola over fraud allegations[1]
September 2020 – Executive Chairman, founder and former CEO Trevor Milton announces his resignation from Nikola[1]
September 2020 – BP (BP LN, BP US) and other energy firms reportedly back away from hydrogen refueling stations agreement with Nikola.[1]
November 2020 – General Motors revises agreement with Nikola and no longer takes a 11% stake and scraps plans to build an electric pickup truck called the Badger for Nikola.[1] Nikola signs a non-binding Memorandum of Understanding (“MOU”) with General Motors for a global supply agreement.[1]
July 2021 – The Securities and Exchange Commission charges the founder, former CEO and former executive chairman of Nikola Corporation, ‘for repeatedly disseminating false and misleading information’.[1]
July 2021 – Nikola issues statement that the government actions are against Mr. Milton individually, and not against the company. ‘The company has cooperated with the government throughout the course of its inquiry. We remain committed to our previously announced milestones and timelines and are focused on delivering Nikola Tre battery-electric trucks later this year from the company’s manufacturing facilities’.
Nikola’s share price (NASDAQ: NKLA) Source: Bloomberg Finance L.P
Paid for doing good
Going short or shorting an unsustainable corporate should be viewed as an acceptable investment strategy for the ESG investor. It is an indicator that sustainable/ESG investing is maturing and starting to use the same investment techniques available to the rest of the market. Shorting can accelerate the process of reallocating capital to the sustainable corporates, or those with credible transition plans, and effectively penalise those that are pursuing unsustainable business models (or, even worse, using greenwashing to disguise their activities). We believe that this will prove particularly valuable to the cause of sustainability in capital markets. Not only would this promote sustainable credentials but also enhance investor returns while doing so. Now we are speaking the language of the financial markets!
[1] Naked shorts are when the investor sells securities, but they have not secured an allocation of shares or borrowed them. Traders must usually borrow the stock before shorting. This practice was largely banned after the 2008/9 financial crisis.
[2] In this paper we use sustainable and ESG synonymously
[3] https://www.iosco.org/library/pubdocs/pdf/IOSCOPD292.pdf
[4] https://www.aqr.com/Insights/Research/Journal-Article/Taxes-Shorting-and-Active-Management
[5] https://www.ft.com/content/6424d306-8b47-11dd-b634-0000779fd18c
[6] https://www.reuters.com/article/us-japan-gpif-idUSKBN1Y71F6
[7] https://www.ft.com/content/9b228d14-1c34-11ea-97df-cc63de1d73f4
[8] https://www.schroders.com/en/insights/economics/are-short-sellers-ethical/
[9] https://www.whitecase.com/publications/alert/short-selling-bans-and-market-restrictions-considerations-investors
[10] https://gpssl.org/wp-content/uploads/2021/03/Global-PSSL-Market-standard-on-short-activism-30-March-as-introduced.pdf
[11] Lou, X, Karpoff, M. J. 2010. Short Sellers and Financial Misconduct. The Journal of Finance Vol 65 (5)
[13] https://www.aima.org/static/8eac1e4b-e7d1-42c0-baebdf4a3bc8540a/1772020-AIMA-Short-Selling-and-Responsible-Investment-V6-4.pdf
[14] https://www.aima.org/static/8eac1e4b-e7d1-42c0-baebdf4a3bc8540a/1772020-AIMA-Short-Selling-and-Responsible-Investment-V6-4.pdf
[15] https://www.reuters.com/business/energy/bhp-talks-sell-global-oil-gas-business-australias-woodside-2021-08-16/
[16] https://amp-theage-com-au.cdn.ampproject.org/c/s/amp.theage.com.au/business/banking-and-finance/super-funds-could-short-heavy-emitters-to-meet-net-zero-targets-us-hedge-fund-titan-warns-20210822-p58kw8.html?utm_source=pocket_mylist
[17] https://www.aqr.com/Insights/Perspectives/Shorting-Your-Way-to-a-Greener-Tomorrow
[18] https://www.aqr.com/Insights/Perspectives/Shorting-Your-Way-to-a-Greener-Tomorrow
[19] Long-short investment strategies buy undervalued stocks that the investment managers believe will rise in price, while simultaneously shorting overvalued stocks in an attempt to reduce losses. This strategy is designed to have lower sensitivity to equity market movements.
[20] https://img1.wsimg.com/blobby/go/946d6aac-e6cc-430a-8898-520cf90f5d3e/LeveragedCarbonFootprinting.pdf
[21] https://www.ft.com/content/b8c91561-b44c-43cf-9810-7aeff9c377a8
[22] https://www.fnlondon.com/articles/wirecard-shows-why-bans-on-short-selling-are-badly-misguided-20200819
[23] https://hindenburgresearch.com/loop/
