The World's Biggest Pension Fund May Be Wrong About Short Sellers
Japan's Government Pension Investment Fund (GPIF) is the largest public pension fund in the world. With $1.6 trillion in its asset portfolio, the Fund is managed by a host of blue-chip money managers such as Morgan Stanley (NYSE:MS), BlackRock (NYSE:BLK) and Baillie Gifford.
The GPIF's actions and allocation decisions can have far-ranging effects. Thus, its 2019 decision to end its practice of lending stock to third-party investors has sent shockwaves across the financial world. Short sellers, who use borrowed shares to bet against stocks, will be the most affected.
The GPIF claimed that it would consider lending shares again if better controls and transparency around end borrowers are enacted. In other words, the fund intends to restrict its lending to short sellers over the long-run. In my opinion, this is bad news for capital markets.
Proper investment stewardship
Leo Lewis and Billy Nauman discussed the GPIF's rationale for ending its stock lending practices in a Dec. 3, 2019 Financial Times article:
"The GPIF said it was concerned that lending stocks out stopped it exercising proper stewardship over the underlying investments. This included a lack of transparency over the final borrower and how it was using GPIF shares."
When a company lends its shares, it surrenders some - often all - control over how those shares are used. Thus, a borrower can exercise the stock's voting power (as long as they don't short it, in which case the voting rights are transferred to the person buying from the short-seller).
A real opportunity cost
The GPIF's decision to suspend its stock lending practices will come with a steep price, as Lewis and Nauman observed:
"The decision will incur a direct financial cost to the Japanese fund. According to the GPIF's most recent annual report, it declared a net $375m in fees from lending shares that sit in the foreign segment of its portfolio over the past three years to 2018."
A few hundred million dollars may not seem like much for a fund managing a $733 billion global equities portfolio, but all profits matter for a pension fund that must support an ageing population. Stock lending is essentially free money for the lender, adding to margins and income in a meaningful way. Thus, as the FT's Lex column observed in December, the GPIF's decision to do away with a "nice little earner" amounts to "scoring an own goal." However, foregone income is ultimately only a minor issue.
Following the leader
The GPIF's decision, taken in isolation, does not look like too big a deal. However, its size and influence on capital markets means that others might follow suit. If a large number of big allocators and investors were to abandon stock lending, it could damage the price discovery mechanism that is crucial to the maintenance of well-functioning capital markets. According to finance professor Ekkehart Boehmer, short-sellers actively improve market pricing accuracy:
"Stock prices are more accurate when short sellers are more active. First, in a large panel of NYSE-listed stocks, intraday informational efficiency of prices improves with greater shorting flow. Second, at monthly and annual horizons, more shorting flow accelerates the incorporation of public information into prices. Third, greater shorting flow reduces post-earnings-announcement drift for negative earnings surprises. Fourth, short sellers change their trading around extreme return events in a way that aids price discovery and reduces divergence from fundamental values."
The value that short-selling adds to the price discovery process has been catalogued by financial professionals and academics alike over the years. This hefty body of work is not lost on everyone at the GPIF. Indeed, there are reports of internal strife at the GPIF over the issue.
Disclosure: No positions.
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This article first appeared on GuruFocus.
