The Case for More Short Selling

Should pension funds be short sellers? A forthcoming paper in the Boston University Law Review suggests they should.

By engaging in more short selling, institutional allocators like pensions and endowments could better capitalize on negative market information and exert more influence over corporate governance and public policy, according to authors Peter Molk (University of Florida) and Frank Partnoy (University of California, Berkeley).

“In many circumstances, institutional investors do not appear to engage in meaningful short selling despite potential gains and an absence of formal barriers,” the two law professors wrote. “We have sought to demonstrate that institutional shorting is a viable strategy, with potentially promising gains to the investors and, in some cases, to society at large.”

Currently, short selling accounts for about a quarter of all U.S. stock market trading, according to the paper, which cited a 2017 study by business school professors Eric Kelley and Paul Tetlock. Aside from hedge funds, however, institutional investors are “largely absent from this important part of the market,” Molk and Partnoy concluded.

“There are some obvious reasons for institutional investors to avoid short selling,” they acknowledged, noting the costs and risks involved in the practice, as well the cultural and regulatory obstacles allocators might face. These included the loan fees charged to borrow shares for a short position and the infinite potential losses from a stock going up indefinitely. Although the authors noted that most institutions are not directly prohibited from short selling, some, like insurance companies, are.

“Most fundamentally, to the extent that the stock market overall generates positive returns, short sellers on average can expect, other things equal, to lose money,” Molk and Partnoy wrote.

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With so many downsides, why should institutional allocators short stocks? Molk and Partnoy offer five main advantages to investors and the market at large: more accurate securities prices; greater management discipline among corporate leaders wary of being shorted; more pressure on policy solutions for shorting and lending problems; increased visibility of voting, dividend taxation, and bankruptcy issues; and stronger engagement with public policy.

“Increased institutional shorting could enhance institutions’ ability to pursue social goals on behalf of their investors by increasing the financial rewards from furthering these goals,” they wrote. As an example, the authors noted that a foundation like the Rockefeller Brothers Fund, which almost entirely divested from fossil fuels, could go one step further by shorting coal companies.

“If coal companies were to become less valuable over time (perhaps in part due to institutional investors’ attempts to manage greenhouse gas emissions), shorting those companies today offers the prospect of financial returns from policy engagement,” the law professors argued. “Current strategies of divesting holdings merely offers the prospect of avoiding future losses.”

Even outside the realms of environmental or socially responsible investing, short selling still offers opportunities for investors to profit off of negative information, Molk and Partnoy said. “By shorting the affected security, investors can profit directly from discovering and releasing the negative information,” they explained, noting that this is the strategy employed by many hedge funds.

To increase their short exposure, the pair suggested that institutional investors either participate indirectly — by investing in a short-selling hedge fund — or take direct short interests in securities themselves. In general, they recommended that allocators incorporate short selling into their investment strategies by building, for example, a leveraged portfolio that is 110 percent long and 10 percent short.

“In advocating that institutional investors embrace short selling, we suggest that short selling might be viewed in the same way public law scholars view some free speech actors: outlier participants in society who do not represent the views of the majority and who seek changes that would harm certain powerful institutions and individuals, but whose efforts and positions nevertheless can effect changes that significantly benefit society overall,” the authors concluded.