short selling, evil or necessary evil

[larryswedroe]

short sellers often get blame, especially from politicians looking for scape goats instead of looking in mirror. However, IMO short sellers provide a valuable social function, helping to keep price discovery efficient which helps to allocate capital

http://www.cbsnews.com/8301-505123_162-57566633/short-selling-evil-or-necessary-evil/

Also what's nice is that even passive investors benefit from short sellers as they can generate significant securities lending fees.

Larry

[Mill]

Very informative article Larry, thanks for posting. But can you further explain what you mean regarding the following statement to a novice. Im afraid I dont follow.

Also what's nice is that even passive investors benefit from short sellers as they can generate significant securities lending fees.

[LazyNihilist]

I understand short selling and agree that it is an important part of the market.
What I have a problem with is naked short selling. Why even allow someone to sell something they don't own/have?

[starsfan18]

Here's my very poor explanation from the 30,000' view: Short sellers sell securities (stocks) that they don't own. They borrow the shares from the owner, sell them, and if their plan works out they purchase replacement shares at a lower cost at a future time, at which point they return them to the lender. The owner of the shares gets compensated by the short seller for borrowing the shares in the form of a fee.

At least that's how I understand it to work.

[Mill]

Here's my very poor explanation from the 30,000' view: Short sellers sell securities (stocks) that they don't own. They borrow the shares from the owner, sell them, and if their plan works out they purchase replacement shares at a lower cost at a future time, at which point they return them to the lender. The owner of the shares gets compensated by the short seller for borrowing the shares in the form of a fee.

At least that's how I understand it to work.

I thought passive investors benefit by getting the yield from loaning shares to the short sellers? Or is a fee charged? And also how is it paid? Is it reflected in the stock dividends?

[LadyGeek]

From Wikipedia (Short (finance)) and elsewhere, I learned that it's best to replace the term "short" with "borrowed." Everything falls into place, as when you sell the shares, you will have to give them back to the original owner.

If the price goes down, you buy the replacement shares at the cheaper price and give those back to original owner. You keep the difference, life is good.

If the price goes up, you have to fork out extra cash for the replacements which go back to the original owner.

The original share owner makes a profit by charging you for the privilege of borrowing the shares.

Simple, but it works.

[magician]

Very informative article Larry, thanks for posting. But can you further explain what you mean regarding the following statement to a novice. Im afraid I dont follow.

Also what's nice is that even passive investors benefit from short sellers as they can generate significant securities lending fees.

Short selling means that you sell a security today, then buy it back in the future; as always, you hope to buy low and sell high, so that means that you benefit when the price drops.

However, to sell the security today - before you've bought it - you need to borrow it from someone who owns it. That person charges the short-seller the lending fee to which Larry refers: it's the rent that the short-seller pays to the owner of the security (the lender) to use it for a while. When the short-seller buys the security back in the future, he returns it to the lender.

Suppose that Bob thinks that the price of Apple stock is going down. If he owns some Apple stock, he sells it, then buys it back later after the drop. If he doesn't own any Apple stock, he borrows some from Larry and sells it. Later, he buys it back and gives it back to Larry. Larry charges Bob $100 rent for the Apple stock; that $100 is the lending fee.

[magician]

I do take exception to the title of this thread; short selling is not evil, whether it's necessary or not.

[Mill]

I appreciate the posters taking the time to explain short selling, and I understand the process. My question is about the fees specifically.

Are the fees paid back to the company that they are shorting, and then in turn paid out to (long) investors as stock dividends?

The fees have to go somewhere, and its hard for me to explain what I am asking, but I know when I log into my VG account it will never show me a message saying "Welcome Mill....Someone decided to short 500 shares of your x security, and therefore you are rewarded with $y as the fee."

So how are the fees paid back to me? (as a long term passive investor)

Thanks

[magician]

I appreciate the posters taking the time to explain short selling, and I understand the process. My question is about the fees specifically.

Are the fees paid back to the company that they are shorting, and then in turn paid out to (long) investors as stock dividends?

The fees have to go somewhere, and its hard for me to explain what I am asking, but I know when I log into my VG account it will never show me a message saying "Welcome Mill....Someone decided to short 500 shares of your x security, and therefore you are rewarded with $y as the fee."

So how are the fees paid back to me? (as a long term passive investor)

Thanks

The fees are paid to the owner of the shares who lends them to the short-seller.

Your VG account wouldn't lend your shares to someone else without your permission, so you'll never get such a message. I suppose that one of VG's mutual funds could lend its shares (of, say, Apple) to a short-seller; in that case, the fee would go to the mutual fund, and show up as an increase in the NAV.

[Mill]

The fees are paid to the owner of the shares who lends them to the short-seller.

Your VG account wouldn't lend your shares to someone else without your permission, so you'll never get such a message. I suppose that one of VG's mutual funds could lend its shares (of, say, Apple) to a short-seller; in that case, the fee would go to the mutual fund, and show up as an increase in the NAV.

interesting.

Thanks for the explanation.

[jdilla1107]

Short sellers help passive investors in another way too. They help ensure we don't over pay for companies.

It's also good to have an incentive for uncovering fraud.

[Phineas J. Whoopee]

The fees are paid to the owner of the shares who lends them to the short-seller. ...

Hi magician,

It depends on the brokerage. I have (but don't use) a margin account at Schwab, and carefully read through all the pages of paper.

In order to sell short you have to have a margin account in the first place - I imagine that must be the case everywhere.

By having an individual margin account at Schwab, you are giving them authority to lend out your securities without your knowledge, and to keep the fee for themselves.

I wouldn't be surprised if that was common, but I don't know it, so I'll confine my remarks to the one broker I do have the information about.

It works rather like fractional-reserve banking. I feel like I own 100 shares of FSCR, and the person the short seller sold to feels like they also own it. The share borrower has to pay me the same cash flows I would have had from the company, on time. I could sell my shares, and other buyer could sell theirs. When that happens the brokers shuffle more borrowed shares among themselves. I would never know if my shares were borrowed from me; nor know if I bought shares that had been borrowed from somebody else.

With Vanguard we're lucky. They receive the fee but apply it against fund expenses for us.

PJW

[magician]

The fees are paid to the owner of the shares who lends them to the short-seller. ...

Hi magician,

It depends on the brokerage. I have (but don't use) a margin account at Schwab, and carefully read through all the pages of paper.

In order to sell short you have to have a margin account in the first place - I imagine that must be the case everywhere.

By having an individual margin account at Schwab, you are giving them authority to lend out your securities without your knowledge, and to keep the fee for themselves.

I wouldn't be surprised if that was common, but I don't know it, so I'll confine my remarks to the one broker I do have the information about.

It works rather like fractional-reserve banking. I feel like I own 100 shares of FSCR, and the person the short seller sold to feels like they also own it. The share borrower has to pay me the same cash flows I would have had from the company, on time. I could sell my shares, and other buyer could sell theirs. When that happens the brokers shuffle more borrowed shares among themselves. I would never know if my shares were borrowed from me; nor know if I bought shares that had been borrowed from somebody else.

With Vanguard we're lucky. They receive the fee but apply it against fund expenses for us.

PJW

When I wrote my answer above I wasn't thinking about a margin account, but one's investment portfolio. Obviously, if you deposit assets with a broker in a margin account you are, to a certain extent, pledging them for use by the broker, so it's (somewhat) understandable that the rules would be different. I'm a bit taken aback that they can lend those assets and keep the rent - they're not entitled to, say, the coupon payments that you would receive on bonds that you deposit - but if that's the arrangement to which you agree, then you're stuck with it. If I needed a margin account I'd look for a broker other than Schwab.

[Don Christy]

Also what's nice is that even passive investors benefit from short sellers as they can generate significant securities lending fees.

Larry

I've often wondered how much counter-party risk securities lending introduces to Vanguard funds and whether we can easily determine if the risk is being well compensated. Anyone explored this in dtail? Is Vanguard transparent with the details?

[Don Christy]

Also what's nice is that even passive investors benefit from short sellers as they can generate significant securities lending fees.

Larry

I've often wondered how much counter-party risk securities lending introduces to Vanguard funds and whether we can easily determine if the risk is being well compensated. Anyone explored this in dtail? Is Vanguard transparent with the details?

Of course, I could have found most of what I wondered about with a 1 minute search. There are several threads here covering securities lending at Vanguard. This one links to a Vanguard paper with a lot of detail:
Securities Lending:still no free lunch

From that Vanguard paper:

Vanguard’s approach to securities lending
Vanguard has designed its securities-lending program to capture the scarcity premium
found in many hard-to-borrow securities and
to conservatively reinvest the cash collateral (Vanguard, 2009). Lending scarce, high-demand securities results in a lower percentage of assets lent from a fund as well as a higher return per dollar of assets lent. And the low-to-negative rebate rates associated with hard-to-borrow securities translates into a larger percentage
of lending revenues retained by the fund.
The cash collateral received is reinvested in a diversified portfolio of high-quality, short-term,
fixed income instruments such as short-maturity government securities, repurchase agreements, and bank certificates of deposit; the dollar-weighted average maturity of such portfolios is 60 days or less and their dollar-weighted average life is 120 days or less. Structured investment vehicles
(SIVs) and other structured-finance instruments
are not approved for investment. These guidelines apply to both Vanguard’s U.S.-domiciled and non- U.S.-domiciled funds. Vanguard Fixed Income Group manages the cash pool in-house for its U.S.-domiciled funds and commingled trusts; for
its non-U.S.-domiciled funds, it has strict collateral reinvestment guidelines and closely monitors lending-agent activity. These conservative investment guidelines for the cash-collateral pool are designed to maintain the liquidity of the collateral pool and to minimize the risk of loss to fund investors by focusing on principal preservation.
To reduce the risk of counterparty default, Vanguard lends securities to a limited number
of preapproved broker-dealers and maintains
strict internal guidelines on the aggregate dollar amount of loans to any one approved borrower.
In addition, Vanguard ensures proper collateral coverage by valuing the loaned securities on a daily basis—using current market prices—and
by calling for additional collateral when necessary to bring the coverage levels up to the 102% or 105% floor levels for U.S. or foreign securities, respectively. Vanguard’s agency agreement requires the lending agent to indemnify our fund in the case of a counterparty default by replacing either the security or the security’s current market value to the fund.
Further, the correlation between equities and money-market-like securities has historically been much lower than the positive correlation between less creditworthy, longer-term fixed income securities and equities. Thus, our more conservative reinvestment strategy may also enhance the overall portfolio’s diversification, lowering its total risk.
Finally, Vanguard returns all net lending revenues—after subtracting program costs, agent fees, and any broker rebates—back to the funds.8 These securities-lending practices help ensure a superior risk–reward trade-off in the best interests of Vanguard’s clients.

[SPG8]

Short sellers help passive investors in another way too. They help ensure we don't over pay for companies.

It's also good to have an incentive for uncovering fraud.

I agree.

I'm not terribly concerned about it, but do wonder about the role of index funds and passive investing over the long term. Poked around and saw that the percent of index funds as a share of mutual fund total net assets has increased steadily from 6.6% in 1997 to 16.4% in 2011.

Also wonder who votes at shareholder meetings anymore, and how that compares to, say, 1975, and whether any differences would amount to anything.

Just basically wonder who's watching the henhouse?