As ESG becomes a growing priority for asset managers around the world, some still question whether short selling is compatible with responsible investing has been raised time and again. Now, AIMA argues that short selling is not only compatible but an essential tool in the toolbox for any ESG minded investor
For many outside of our industry, when short selling comes to mind it conjures images of a pernicious market naysayers working to drive down the prices of your favourite stocks and undermine market stability for their own gain.
The general consensus is that the typical short seller is disliked because they go against the herd in bull markets. As Matthew Chessum, investment director at Aberdeen Standard Investments, puts it: “Short selling has been considered the devil’s work for a long time now.” The reality is that, more often than not, this perception of short sellers is more applicable in describing their targeted companies.
Short sellers have been castigated as the bogeymen of the market and used as a scapegoat for every wobble or downturn for as long as the stock market has existed. But, now these professional sceptics face a new threat: being labelled ‘anti-ESG’. Environmental, social and governance (ESG) is the umbrella term used to define the favouring of responsible investment strategies that shy away from ‘bad’ sectors, such as carbon-intensive energy production or armaments manufacturing. What is ESG friendly or not is an evolving issue based on individual perception. Some managers are simply divesting their exposure to oil, while others are going much further and reviewing the appropriateness of facilitating short selling through their securities lending programme, due to its perception as a negative market force. Until now, most of the debate has centred on whether short selling and ESG can co-exist. But now one trade body is going on the offensive and taking the argument one step further.
A new paper by the Alternative Investment Management Association (AIMA) and global law firm Simmons & Simmons argues that short selling is, in fact, “essential” in enabling positive change in the market. Moreover, the paper says that short sellers bolster market transparency by uncovering corporate wrongdoing and environmental negligence and suggests that shorting can help in achieving two key goals for responsible investors: mitigating undesired ESG risks, such as climate damage, and creating an economic impact by influencing the nature of capital flows through ‘active’ investing.
AIMA believes there is a “pretty watertight case that short selling is a valuable tool in the context of responsible investment. That said, firms that want to do more in terms of responsible investment will ultimately form their own conclusions about how it relates to their business, based on their investment strategy and what their investors want.”
The association concludes that short selling needs to be encouraged and will not only be an excellent tool for furthering ESG strategies, but an invaluable one. Tom Kehoe, AIMA’s global head of research and communications, explains that the association has “devoted significant energy to the topic of responsible investment in recent years”.
“Tackling the role of short selling felt like an obvious next step in our work, given it is a core investment technique for so many hedge funds and given the lack of guidance on this in the market,” he adds.
Meanwhile, Aberdeen’s Chessum notes: “The question regarding short selling and ESG only helps to solidify the case for the existence of short selling within financial markets. Good liquidity and fairer pricing helps to create broader and deeper financial markets which benefits not only investors but companies looking to raise finance which eventually filters through to the average person on the street.”
World economies are facing growing debt and unsustainable asset prices as the world enters an unsettling reality after the pandemic, ESG is now seen as a key factor in many hedge funds’ portfolio-building processes, as boardrooms grapple with more ongoing challenges such as climate change and improving corporate governance.
For example, multiple studies of funds’ performance compared to various indexes for the first half of the year has shown that the more ESG-focused a fund is in its investments, the better it has performed.
Kehoe adds: “For firms that want to remain at the cutting edge in the field, then maximising the tools at their disposal is vital.”
Admittedly, those who do not have helping hedge funds with their bottom line as high on their priorities may not yet be convinced. But, the real power of short selling as an ESG tool comes when it is applied by so-called ‘activist short sellers’, such as in the recent Wirecard debacle.
“Poor management, bad environmental records, corruption and a whole other multitude of sins are actively sought out by activist hedge funds looking to hold companies to account. Shorting is a great way of expressing these concerns.” Chessum continues. “The fact that short sellers now also look to actively call out companies that are not meeting the standards expected by investors is of additional benefit to society.”
Sam Pierson, director at IHS Markit, is of the same opinion and agrees with the points made in the report, in that short selling can facilitate hedging of ESG risks for asset managers and provides a vehicle for exposing ESG and other risks. “The paper focuses on the environmental component, however, there is also a direct link between short selling and governance that may not receive enough attention,” he says. “Considering the importance of capital structure decisions to corporate governance, short selling is a critical structural component.”
Short-term ESG trading opportunities are a new reality and are undergoing a radical evolution. Traditional ESG funds are breaking etiquette and copycatting hedge fund long and short strategies, short selling has historically been a tool used mainly by hedge funds. Given its power and hopefully it’s better understood and restored reputation, given recent events in Germany, Chessum questions whether the more mainstream institutional investors should now engage more heavily in this strategy to pursue their own ESG strategies.
“Is stock selection alone enough or do larger institutional investors also have a responsibility to actively call out those companies who fall short in their social responsibility?” Chessum queries.
Elsewhere, Peter Hillerberg, co-founder of data analytics firm, ORTEX Analysis, explains that high levels of short interest would not always indicate that a company has underlying failings in factors that contribute towards a positive ESG angle. “However, if there are large short positions building, from several hedge funds, there will be a reason why and it can serve as an extremely useful potential red flag.”
Ihor Dusaniwsky, managing director at S3 Partners, embellishes the point: “In a perfect world, the negative ESG stock price effect of short selling would force a change in corporate culture\activity and raise corporate ESG scores in the longer term.
“While positive reinforcement, stock buying, is an effective reward for high scoring ESG companies, short selling would provide a swift kick to a CEO’s stock options and provide the incentive for companies to improve their ESG scores.”
A fund manager simply seeking to boost returns during these unsettled times may wish to apply an ESG lens to their investment strategy that only serves to sift out unsuitable sectors. But, those wishing to bring about positive change to financial markets and the real economy should throw their weight behind the short sellers that have proven themselves time and again to be among the most responsible investors of them all.
