For responsible investors, the question of whether short selling is a practice they should shun or embrace remains as unclear as always. The arguments that short selling in aggregate helps with price discovery and market liquidity have yet to dispel the public perception of the strategy as unethical. Reddit activists have recently joined the discourse, reinforcing the ranks of nay-sayers. Those hoping for regulators to shed more light on the sensitive issue must have been disappointed by the mere acknowledgement that it received in the latest draft of the Regulatory Technical Standards (RTS) of the Sustainable Finance Disclosure Regulation (SFDR).
Short Selling 101: The Pros and Cons
Short selling is an age-old strategy employed as early as the 16th century by the famous Dutch tulip traders. The principle is simple: for an investor who identifies an overvalued financial asset, selling this asset ‘short’ provides an opportunity to benefit from its expected price correction. ‘Naked’ selling (the notion of selling a security without any underlying asset) is no longer legal, of course, so short sellers first have to borrow the asset. Then, once the position has depreciated sufficiently, they hope to buy it back at a profit. Paying interest for borrowing the asset and maintaining a margin account can make the strategy costly even when the bet is correct. And if the trade goes the wrong way, the downside is theoretically unlimited.
Let’s not forget to mention that shorting can also be used to ‘hedge’, meaning that if a short position matches, at least in part, the exposure of a long position (that is a position held in the portfolio) then it can function as a risk mitigator. Whichever the movement of the underlying market, the two positions will move in opposite directions thereby cancelling out the risk attributed to the market.
Critics of the practice do not lack arguments. To start with, they advance, speculating on a price drop is unethical because it means profiting from the demise of others. Think of George Soros, who made billions on the British Pound crash. The strategy is also prone to manipulation, as investors who speculate on a price fall benefit from spreading negative information, even if it is false. Short sellers are also often accused of disrupting the market as they have the ability to transform downturns into full-blown panics.
Proponents of the strategy counter with two main arguments, supporting their claim that short sellers make financial markets more efficient: they enhance market liquidity and help determine the correct price of assets. Evidence collected during periods of short-selling bans, like those imposed by most regulators in the financial crisis 2007-2009, pointed to deteriorating liquidity and slowed price discovery. Moreover, as academic studies have shown, short sellers “play a significant role in identifying and mitigating the effects of financial misconduct.”
Responsible investors need to tackle further challenges when considering short selling. Even those who buy into the benefits of short selling and disregard ethical arguments, need to consider the fact that some of the strategy’s very advantages might turn counterproductive from a sustainability perspective. For instance, a well-intended bet, like shorting ESG laggards or fossil fuels, could end up promoting these assets by enhancing their liquidity.
Where Short Selling Meets ESG
Between regulatory shyness and social media attacks, industry bodies have stepped in to provide some guidance on the benefits of this investment strategy.
According to a joint report by the Alternative Investment Management Association (AIMA) and international law firm Simmons & Simmons, short selling can be used to achieve responsible investment goals. The paper strives to bust the myth that responsible and ESG investing must always be a long-term buy-and-hold strategy.
“Short selling can be an excellent tool for achieving two common goals of contemporary responsible investment: mitigating undesired ESG risks, and, when taken in aggregate, creating an economic impact by influencing the nature of capital flows through ‘active’ investing,” the report states.
AIMA presents strong arguments that hedge fund managers would be better off publishing a net carbon exposure figure than disclosing their gross Weighted Average Carbon Intensity (WACI) score, which would account for their long and short positions. Admitting that this doesn’t solve the problem of funding carbon-intensive businesses through the long positions, AIMA points out that short selling would, in any case, allow hedge fund managers to create a portfolio that is carbon neutral or, theoretically, even ‘short carbon’ in terms of its net carbon footprint.
In the same vein, when it comes to the practice of hedging, it is important to note that even if a position is ‘hedged’, as for example in the case where a long carbon exposure is ‘netted off’ by a short one, the investor remains the owner of the long position. It is therefore tricky to argue that a hedged position is ‘carbon free’.
In their technical guide “ESG incorporation in hedge funds”, published in May 2020, the Principles for Responsible Investment (UNPRI) also acknowledged the potential utility of short selling when implementing responsible investment strategies, albeit in just a few words. The paper states clearly that “short selling is one way for a hedge fund manager to express the view that an entity is not adequately incorporating ESG factors.”
Short Selling Activists Step Up the War on Greenwashing
Since short-sellers are particularly adept at exposing companies that have improperly inflated their performance or misled investors, short-selling could be valuable to sustainable investors by helping them identify potential green-washers undermining the ESG market.
According to Nathan Anderson, founder of successful short seller Hindenburg Research, the ESG sector is particularly fertile ground for companies that overstate what they do. “When people feel good about giving away their money or investing their money, they are less likely to scrutinise where it’s going.” An example of this chain of events was the case of Nicola, an electric truck start-up shorted by Hindenburg, which had to admit that it did roll one of its trucks down a hill in a video that made the vehicle look like it was capable of moving under its own power.
Despite their unflattering reputation, short sellers might prove to be well-suited for the task of curbing the enthusiasm of over-eager investors, who do not have the patience or the expertise to conduct their due diligence properly. Even busy financial regulators concerned about insufficient resources should be grateful to short sellers for the help they get in uncovering frauds.
The Short of it
As always, there is no silver bullet, no one-size-fits-all and the devil is in the detail. No wonder regulators haven’t yet issued clear guidelines endorsing or undermining short selling in the context of sustainable finance. The market needs protection from investors going rogue, but a diversity of strategies and financial creativity can also bring along positive change. Transparency is one aspect that should, no doubt, be encouraged and that is precisely what the new disclosure regulation is attempting to achieve.
For now, it is crucial to remember that short selling, just like other investments involving derivatives or leverage, comes at a significantly higher risk than simply buying stocks ‘long’, where ‘only’ the initial capital is at stake. For investors willing to take this kind of increased risk, upholding high ethical and ESG standards may prove challenging when the rubber hits the road, as the temptation to stray tends to be stronger when there is more at stake. These considerations need to be firmly anchored into short sellers’ values for them to credibly claim that they belong to the sustainable investing family. With the increasing appeal of applying a coat of green on a new or existing strategy, it is only a question of time until we find out who has been swimming without a proper ESG suit.
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