Is it ethical to short unethical stocks?
A couple of years ago, as we attempted to open a new short position on the fund I was running, an alert flashed up on my screen. The stock in question had just been added to our firm’s ‘controversial weapons’ list and this meant we were no longer allowed to hold it, long or short. While it is clear that investors may not wish to own shares in a firm that isn’t compatible with their ethical principles, it is not immediately obvious how we should think about holding a short position in the same company.
With the rise of both ESG (environmental, social & governance) and absolute return strategies, the question over shorting unethical companies is being raised more frequently. Whenever we think about these issues it can be useful for us to try and assess the impact of the decisions we make.
There have been several arguments made recently that shorting ‘bad’ companies may be a good thing. The industry body the Alternative Investment Management Association (AIMA) has argued that shorting can penalize ‘unethical’ firms by increasing their cost of capital. An established asset manager has also suggested that shorting “may send a strong message to corporate management”.
While it is not generally recommended that investors short firms purely because they find them unethical, what should we do if our investment view leads us to believe a short position will deliver positive returns? There are two reasons why ESG investors may feel comfortable shorting unethical firms. Investors may believe that shorting a firm can in some way lead to positive change in a firm’s behavior. Or investors may feel that shorting a firm causes no harm, and simply want to maximise expected returns.
There are three areas ESG investors need to consider when deciding on whether to short;
How does shorting a firm affect its cost of capital?
If we are taking an activist approach, how might shorting allow us to positively influence firm behavior?
If we are short an unethical firm could we be profiting, or helping others to profit, from an unethical activity?
Cost of capital
What impact does shorting a firm have on its cost of capital? If our actions lower its stock price, we increase the firm’s cost of capital as additional equity would be issued at a lower valuation. Conversely, if our actions increase the stock price, we lower the firm’s cost of capital. ESG investors typically want to avoid doing the latter.
So, does shorting always lead to lower stock prices? Not necessarily.
It is true that the temporary increase in supply resulting from a short sale can have a negative impact on a stock’s price, but that is an oversimplification. Short sellers can also, counter-intuitively, have a positive impact on stock prices.
Many funds engaged in short selling are effectively acting as market makers, providing liquidity to buyers and reducing bid/ask spreads (the gap between the prices stocks can be bought and sold). All else being equal, investors may pay more for a more liquid stock, with tighter bid/ask spreads.
In addition, when short sellers step in to smooth out short-term price dislocations, short selling has the potential to reduce the volatility of a stock. Again, all else being equal, investors may pay more for a less volatile stock.
We cannot assume that short selling will always lead to lower stock prices, increasing a firms cost of capital. Indeed, in some cases, it may even have a positive impact on prices, leading to a lower cost of capital for the firm in question.
Shorting as an additional activist’s tool
If we take an activist approach, it is worth noting that short positions confer no shareholder voting rights and so traditional forms of management engagement are not available to us. The argument often made is that CEO’s do not like short sellers and may find them difficult to ignore. It is not hard to find examples of this animosity. Tesla’s Elon Musk once said short sellers were “jerks who want us to die”, and Cleveland Cliffs’ CEO famously threatened "We are going to screw these guys so badly … they will have to commit suicide.". While a CEO may dislike short sellers, will that lead to positive change in the behavior of the firm? Given that investors may remain short, even if ethical concerns are resolved, it seems unlikely to provide a strong motivation for change.
Profiting from a firm’s unethical activities?
Finally, when we hold a short position we are not entitled to receive dividends and we do not gain from increases in stock price, so it could be argued that we are not directly profiting from a firm’s unethical activities. Despite this we are paying, in some cases significant, borrow fees to the owner of the stock we borrowed to sell short. This means that there is a risk that we are increasing the overall return to owners of the firm. We may not be comfortable doing this.
Tread carefully
Short selling has an important role to play in an efficiently run market, and can aid price discovery. However, when it comes to ESG investors shorting unethical firms, it is not clear that this will always have the positive or neutral impact investors desire. It seems unlikely to drive positive change in company behavior, it has the potential to lower an unethical firm’s cost of capital, and, through payment of borrow fees, we could also be lowering the cost of ownership for current owners of the firm’s shares.
Where we are uncertain of the impact we may have, the principle of primum non nocere may be applied. First, do no harm. ESG investors should tread carefully when considering shorting stocks they deem unethical.