As important sources of stocklending, pension funds are under pressure to ensure they are not enabling damaging short selling. David White reports

Should pension funds withdraw from stocklending if they believe that the practice is leading to disorderly markets and financial instability?

This question has been posed in the wake of regulatory concerns about the impact of short selling on recent rights issues in the UK and share prices in the US.

Pension funds are involved in short selling to the extent that they are important sources of stocklending. They may therefore find themselves lending stock to hedge funds that might short the stock to drive its share price down.

Regulators have been sufficiently worried about the impact of this kind of short selling in current conditions to introduce emergency orders to try to limit the impact they believe it is having on markets.

In the UK the Financial Services Authority (FSA) has introduced a disclosure regime for ‘significant’ (0.25%) short positions in companies undertaking rights issues.

In the US the Securities and Exchange Commission (SEC) has moved against the practice of ‘naked shorting’ where the short seller sells a stock with no intention of borrowing it. Investors will be required to actually borrow stock in vulnerable institutions - Fannie Mae and Freddie Mac and 12 Wall Street brokerage firms - if they intend to short them.

As important sources of stocklending, pension funds have two options. The first is to withdraw from stocklending altogether. The second is to recall the stock they have lent or withhold it from the market in certain situations.

Two leading Dutch funds, ABP and PPGM, took the extreme option of withdrawing from the market altogether in 2002. They also wrote to 50 of the world’s largest pension funds urging them to do the same.

The aim was to restore market stability, rather than abjure stocklending. A letter signed at the time by the then chief investment officers of PGGM and ABP, Roderick Munsters and Jean Frijns, suggested to the pension funds that “by joining us in the temporary suspension of stocklending activities, all of us could benefit from a return to orderly market behaviour”.

Withdrawing totally from the market is a drastic measure and in the case of ABP and PGGM it was only temporary. Recalling lent stock or withholding certain stock from lending is seen as a better way forward.

In the UK, Hermes Investment Management has led the way with a code of best practice for stocklending, which is now applied by all Hermes clients, including the BT Pension Scheme.

Paul Lee, (pictured right) a director at Hermes Investment Management with responsibility for stewardship teams for the UK, Americas, Africa & Australasia in the Hermes Equity Ownership Service, is one of the architects of this code.

He believes that a total withdrawal from stocklending by pension funds is not the best way to prevent the shorting of rights issues.  “A blanket ban is actually an extremely inefficient way of going about it,” he says.

“Yet in certain circumstances you do need to consider recalling the stock and making sure that the stock that you are lending is not being used in ways that are actually detrimental to the long-term value of the fund.

“Those circumstances are ex-tremely few and far between, so there is a need for a structure and a framework that highlights when it is and is not appropriate to lend stock, and where it might be necessary to consider recalling lent stock.”

Rights issues may be one of these circumstances. The Hermes code suggests, for example, that responsible long-term investors consider recalling stock in companies that might be carrying out a corporate action such as a rights issue which might invite a technical price squeeze and short selling.

The effects of short selling on a rights issue could affect pension funds directly or indirectly, Lee says.  Directly, a rights issue might fail. “That obviously would be bad for the company in which the pension funds are invested and would clearly not be in their interest.”

Indirectly, a rights issue which flopped but did not fail could push up costs of future underwriting - a cost which will ultimately be borne by all shareholders, including pension funds. “If the short selling has the result that the underwriters are stuck with a lot of stock, and therefore will charge more the next time around, then every pension fund will face the cost of that lending through higher underwriting fees on every subsequent rights issue,” he says.

“Therefore, the more people start to apply sensible policies, the more effective the market will be and the less inappropriate behaviour will happen,” Lee continues.

Awareness of the meaning and implications of stocklending is paramount, he suggests. “The term stocklending is actually a misnomer. Pension fund trustees need to be aware that if they are lending stock that means they are not the current owner of that stock. The fact that it’s called stocklending doesn’t stop it being a sale of the shares. Many trustees clearly do not understand that, and they need to.”

The Hermes code of best practice has stood the test of the five years since it was drafted, he adds. “The code has proved to be robust, and our various clients apply it in practice across their portfolios. As a result they have a great deal more confidence in their stocklending regimes programmes in general and their discretion to recall lent stock in particular.”

The code could act as a blueprint for other pension schemes, he suggests. “We would strongly encourage other pension schemes to look at the issue and to develop something along these lines.”

The code of best practice is based on the belief that stocklending is an acceptable activity and that, under normal market conditions, pension funds will continue to lend stock. They would only suspend or recall lending in abnormal conditions.

It has even been argued that pension funds and their investment managers have a fiduciary duty to lend stock. The International  Securities Lending Association points out in a recent position paper that “beneficial owners who choose not to lend their securities miss out on potential lending revenue, available at low risk, given standard market practices such as over-collateralisation, daily mark to market, use of industry-standard legal agreements and the ability to recall lent securities on demand.”

Similarly, short selling is an acceptable activity. The FSA concluded its review of short selling practices in 2002 with the observation that: “Short selling is a legitimate investment activity that plays an important role in supporting efficient market.”

Jean Keller, (pictured left) chief executive, Alternative Asset Advisors (3A) an investment manager for a number of funds of hedge funds, including London and Zurich-listed Altin and Alternative Capital Enhancement, blames the recent moral panic over short selling and stocklending  on a confusion of two issues - shorting and market abuse.

“There is no doubt that there has been market abuse and the spreading of false rumours, but this has nothing to do with shorting,” he says. “By and large shorting is a positive activity for markets. It increases liquidity and market efficiency and is, overall, good for investors.

Keller points out that even if an investor wants to abuse the market, selling short is not the most effective way to do it. “From a purely mathematical point of view, you are much better off doing so on the long side than on the short side. Your maximum gain with shorting is doubling your money, whereas the maximum gain is theoretically infinite when you are on the long side.”

Keller says shorting is also no less morally acceptable than going long. “The problem about shorting is it’s seen as socially unacceptable behaviour. Yet you could effectively make the case that if everyone is long-only they will push the stocks price up to the point where a bubble is created. This is also socially unacceptable.”

Shorting accelerates a process of price discovery, he says. Therefore institutional investors with long horizons, such as pension funds, should not withdraw from stocklending

“Long-term institutional investors are chiefly interested in an efficient market because, ultimately, buying stocks is buying future cash flows. If we assume that pension funds and other institutional investors have made a good job of selecting managers and those managers have made a good job of selecting stock, then in the long run the future cash flow will be valued correctly and whether investors are long or short is irrelevant.”