earlier this year, the saga drew attention to the equity lending market, a financial arena relatively few investors are familiar with.
But if you’ve bought an index fund in recent years, there’s a good chance you’ve benefited from the equity loan income the fund earned.
This is the market in which investors borrow stocks that they sell short – betting on falling prices. Lenders are primarily large mutual funds (especially index funds), exchange traded funds, and pension funds. Outstanding stock loans in the United States are valued at nearly $ 1 trillion, according to Peter Hillerberg, chief technology officer at Ortex Analytics, a company that monitors the stock lending market.
The income that can be earned by lending stocks is substantial: about $ 10 billion in total was paid for the privilege of borrowing stocks last year, Hillerberg says. The income from these loans is one of the reasons some index funds are able to keep their expense ratios low.
Only a small percentage of a typical company’s listed shares will be sold short at any given time. Currently, the average for an S&P 500 company is around 1%, Hillerberg estimates. This is not the case for GameStop in January, however. Its comparable ratio on Jan. 14 rose to 175.9%, suggesting that nearly twice as many shares were sold short as shares in circulation.
Although it seems impossible, a perfectly benign explanation exists. Imagine Jack borrows 100 shares of GameStop from Mutual Fund # 1 with the intention of selling them short. When these stocks are sold short, they are bought by Fund # 2. Now Jane also wants to sell GameStop short. She borrows those same 100 shares from Fund # 2, and when she gives them up, they’re bought by Fund # 3. In theory, this process could go on indefinitely, Hillerberg says. “There is no theoretical upper limit on the ratio between stocks sold short and its free float.”
The long and short of it
GameStop shares sold short as a percentage of total shares available to the public
This illustration assumes that the same block of 100 GameStop shares is borrowed, shorted, bought, and loaned again. In fact, there is no way to know if a particular block of 100 GameStop shares bought or sold today is the same one that was traded yesterday. Indeed, once loaned out, these shares become part of the GameStop share’s “fungible pool”, according to Roy Zimmerhansl, director of Pierpoint Financial Consulting and former head of global securities lending at
Mr Zimmenhansl adds that it is also impossible to know precisely how many shares of a stock have been sold short at any given time. This is because there will be occasions when two different clients of the same brokerage firm will take opposite sides of a transaction – one buying and the other selling short. In some cases, the company will not execute these “two transactions on the stock exchange, but rather cross these transactions internally.” Short public interest figures will not reflect this.
Shareholder voting market
Short selling is just one of the uses of the stock lending market. Another is to borrow stocks and vote them in a corporate election.
This is possible because, in corporate law, shareholders retain all the economic benefits of ownership of the shares, including any appreciation in price and dividends, even when the shares are loaned out. The right to vote, however, is held by those who actually hold the shares in their accounts, even if those shares have been borrowed. In effect, the shareholder renounces the right to vote in exchange for an interest on the loan of the shares.
Imagine a proxy context in which dissident shareholders who are the beneficial owners of only a small number of shares hope to win seats on the board of directors of the company. It is possible that dissidents will win these seats by borrowing enough shares the day before the shareholders vote, voting them, and then returning them a day later.
Some think this makes a mockery of shareholder democracy. For some of the same reasons, it is impossible to know at any given time the true short-term interest ratio of a company, a company has no way of knowing for sure who its voting shareholders are at a given time. given time, says Edward Rock, a law professor at New York University. In some tight corporate elections, Professor Rock says, it’s virtually impossible to know who actually won.
To illustrate, it asks you to imagine that you have 100 shares of a stock in your account and, without your knowledge, 50 of them are loaned out. This happens often, as almost always our brokerage accounts are set up to give the brokerage firm the right to lend our stock without telling us. In this particular case, you could vote in good faith your 100 shares and the borrower could vote in good faith their 50 shares.
This is just one example of how voting ambiguities could arise. Professor Rock says, “There is so much friction in the system that in any close election there will probably not be a verifiable answer to the question ‘Who won? “
Need for change?
Many believe that this situation should be changed. But many large institutions, especially index funds, prefer to earn income from equity loans rather than voting for their stocks. This cost-benefit calculation became particularly evident after the Securities and Exchange Commission in 2019 relaxed the rules that had encouraged index funds to vote for their stocks. A study by Edwin Hu and Haley Sylvester of NYU School of Law and Joshua Mitts, professor at Columbia Law School, say equity loans from index funds rose 58% after the SEC relaxed its guidelines.
Professor Mitts adds that this cost-benefit calculation is also relevant to those who fear that, since index funds own large blocks of all companies, they will vote their stocks in a way that discourages competition, preserving some sort of status quo. quo on the market. This may be of greater concern in theory than in practice, he says, because in most cases index funds appear to be eager – some think too eager – to forgo their votes and earn income from loans. ‘actions instead.
Mr. Hulbert is a columnist whose Hulbert Ratings follows news bulletins about investments that pay a fixed fee to be audited. He can be contacted at [email protected]
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