Short Selling: Advanced Concepts - Stocks Under The Hood

The following is a discussion with ChatGPT delving deeper into some advanced concepts in short selling.

Q1. I want to better understand the mechanics of short selling. Is it true that it involves an entity borrowing stock from another entity, paying them a fee for the privilege, selling them on the market and then buying them back and returning them to the lender at some future time?

Yes, that’s a solid high-level summary of how short selling works. Let’s break it down step by step with some additional details:

1. Borrowing the Shares

A short seller (often a hedge fund or a trader) wants to bet that a stock’s price will decline.
They borrow shares from a broker or institutional lender (such as a pension fund or mutual fund), who owns the shares.
The borrower typically pays a fee (stock loan fee) to the lender for the privilege of borrowing the shares. This fee depends on how difficult the stock is to borrow (highly shorted stocks tend to have higher borrowing costs).

2. Selling the Borrowed Shares

Once the shares are borrowed, the short seller immediately sells them on the open market, hoping to buy them back later at a lower price.
The proceeds from this sale go into the short seller’s brokerage account, but they are often required to maintain margin collateral (a portion of the sale proceeds must be set aside as security).

3. Buying Back the Shares (Covering the Short)

At some point in the future, the short seller buys back the shares on the open market.
If the stock price has declined, they buy it at a lower price than they sold it for, locking in a profit.
If the stock price has increased, they must buy it back at a higher price, resulting in a loss.

4. Returning the Shares to the Lender

The short seller returns the borrowed shares to the original lender.
The lender gets their shares back, along with any fees earned from lending them out.

Key Considerations:

Margin Requirements: Because shorting involves borrowing, traders need sufficient margin (collateral) in their account.
Unlimited Loss Potential: Since stock prices can, in theory, rise indefinitely, a short seller’s losses are theoretically unlimited.
Short Squeeze Risk: If many traders are short a stock and it starts rising sharply, they may be forced to buy back shares to cover their positions, causing the price to surge further (this is called a short squeeze).
Dividends and Corporate Actions: If a stock pays a dividend while being shorted, the short seller must pay the dividend to the lender. Stock splits, mergers, and other corporate actions can also impact short positions.

Q2. Ok great. So my next question is this. Once the shares have been leant, does the lender no longer own the shares and hence no longer has any voting rights over those shares?

Yes, that’s correct. Once an entity lends out its shares for short selling, it temporarily loses ownership rights, including voting rights. Here’s how it works:

1. Loss of Voting Rights

When an investor (e.g., a pension fund or mutual fund) lends shares to a short seller, they no longer own the shares during the loan period.
This means they lose their right to vote on corporate matters (e.g., board elections, mergers, shareholder proposals) because they are not the registered owner of the shares at the time of voting.

2. Who Holds the Voting Rights?

The short seller does not have voting rights either because they don’t intend to keep the shares—they are selling them.
The new buyer of the shares (the person who buys them from the short seller) now owns the shares and gains the voting rights.

3. Can the Lender Recall Shares for Voting?

Some lenders (especially large institutional investors) have agreements that allow them to recall their lent shares before key votes (such as takeovers or shareholder activism events).
If they recall the shares, the short seller is forced to buy them back and return them before the vote.

4. Potential Market Impact

In cases of contested votes, large-scale stock lending can reduce the influence of passive funds or institutional investors, shifting voting power to traders who may have different incentives.
Activist investors sometimes try to borrow shares before a vote to influence corporate decisions, though regulations exist to prevent abuses.

Q3. So if the shares were borrowed from say a pension fund, would those shares need to sit outside of a portfolio that may be tracking an index? I mean, if they have been sold, they’re no longer in alignment with the index, right?

Great question! Yes, when a pension fund (or any index-tracking fund) lends out shares, those shares are no longer in their direct possession, which could seemingly create a misalignment with the index they are tracking. However, funds have mechanisms to manage this and maintain index alignment.

1. Collateral Ensures Economic Exposure

When an index fund or pension fund lends out shares, they typically receive collateral in return (usually in the form of cash or other securities).
The fund still retains economic exposure to the stock even though it no longer physically holds the shares.
If the stock price changes, the value of the fund’s assets (including the collateral) still reflects those changes, ensuring that the fund tracks the index effectively.

2. Securities Lending as a Common Practice in Index Funds

Many index-tracking funds (like ETFs and pension funds) engage in securities lending as a way to generate extra income.
The fees they earn from lending shares can offset tracking errors and even improve fund performance.
To prevent any major tracking errors, they often lend only a portion of their holdings rather than all their shares.

3. Portfolio Management Strategies

Some funds will use derivatives (such as futures or swaps) to maintain exposure to the index even if they have lent out shares.
Others may hold back a percentage of shares (i.e., not lend all shares they own) to ensure they always have enough in their portfolio.

4. Does Lending Affect Index Tracking?

In theory, lending shares means the fund no longer directly holds them, but in practice, the collateral + income from lending offsets the impact.
The fund manager ensures that the portfolio remains in line with the index through careful lending policies.

5. What Happens if the Shares Are Recalled?

If a fund needs to recall shares (e.g., for voting or rebalancing), it requests them back from the borrower, who must then return them.
If the borrower can’t return them in time, the fund buys back shares on the market, which could introduce a small tracking error.

Bottom Line

A pension fund or index fund can lend out shares while still tracking the index, thanks to collateral and careful risk management. However, lending out too many shares could introduce tracking errors, which is why funds implement limits on how much they lend at any given time.

Q4. Does it ever result in say an index fund buying more than the index weighting to then lend shares and to the degree that it brings them back to weight? I guess what I’m asking is, do some of the big ETF managers increase their holdings in underperforming stocks to satisfy demand from hedge funds to access shares to sell short?

Yes, that’s a sharp observation! While index funds generally aim to track their benchmark exactly, there are cases where large ETF and index fund managers might adjust their holdings slightly to take advantage of securities lending opportunities. Here’s how and why it happens:

1. ETF Managers Want to Maximize Lending Income

Major ETF providers like BlackRock (iShares), Vanguard, and State Street (SPDRs) earn extra revenue from lending stocks to short sellers.
If there’s high demand for shorting a particular stock (e.g., struggling companies, meme stocks, or highly shorted sectors), the stock’s lending fees can be quite lucrative.
To capitalize on this, some ETF managers might slightly overweight these stocks, increasing their lending revenue while still maintaining acceptable tracking error.

2. How It Works in Practice

Most index funds try to match the exact weightings of an index like the S&P 500, NASDAQ-100, or ASX 200.
However, within their tracking strategies, they have some flexibility:
- Full Replication: Buying all stocks in exact proportion (common in large, liquid indices).
- Sampling: Holding slightly different proportions or a subset of stocks (used in less liquid markets).
Some funds take advantage of this flexibility to increase their position slightly in highly lendable stocks.

3. Why This Matters for Underperforming Stocks

When a stock is heavily shorted, hedge funds and traders need to borrow shares to execute their short trades.
The fees on lending highly shorted stocks can be substantial (e.g., GameStop during the short squeeze, Tesla in the early days).
If an ETF provider knows there is persistent demand for shorting a stock, they may hold a bit more than the index weight, earning lending fees that offset expenses and improve fund performance.
This is especially tempting for passive ETFs with low management fees, where every extra basis point of return from lending is valuable.

4. Does This Affect Market Behaviour?

If large ETFs overweight underperforming stocks just to lend them out, it could create a supply/demand imbalance, where more shares are available for shorting than natural buyers.
This could potentially increase short interest and contribute to downward price pressure on already weak stocks.
On the flip side, if a short squeeze occurs, ETF managers might recall their lent shares, forcing shorts to cover and driving prices higher.

5. Regulatory & Risk Considerations

Index funds still need to closely track their benchmark, so they can’t deviate too much.
There are regulatory limits on how much an ETF can lend out (often around 30% of holdings for U.S. ETFs).
If they overweight a stock too aggressively and it drops further, they risk higher tracking error or liquidity issues.
Some funds cap their securities lending exposure to mitigate risk.

Conclusion

Yes, some large ETF managers strategically adjust their holdings to take advantage of securities lending opportunities, particularly in underperforming stocks with high short-selling demand. However, they must balance this with tracking accuracy and regulatory constraints.

Short Selling: Advanced Concepts

Q1. I want to better understand the mechanics of short selling. Is it true that it involves an entity borrowing stock from another entity, paying them a fee for the privilege, selling them on the market and then buying them back and returning them to the lender at some future time?

Q2. Ok great. So my next question is this. Once the shares have been leant, does the lender no longer own the shares and hence no longer has any voting rights over those shares?

Q3. So if the shares were borrowed from say a pension fund, would those shares need to sit outside of a portfolio that may be tracking an index? I mean, if they have been sold, they’re no longer in alignment with the index, right?

Leave a Reply Cancel reply