NZ Herald 21 April 2018

ALet’s start with what short selling is. Normally you would buy a share because you think it’s price will rise. Say you pay $4 a share, and you’re right — the price rises to $6. When you sell you make a profit of $2 a share.

But with selling short you make a profit if a share price falls. Instead of buying the share at $4, you borrow it for a fee, and agree to give it back later to the lender. Right after you borrow the share, you sell it for $4. Let’s say the share price then falls to $2. At that stage you buy the share back and return it to the lender. You received $4 and later paid $2, so your profit is $2, minus the borrowing fee.

It sounds a bit sneaky. If you borrowed your neighbour’s lawnmower and sold it, and then bought back an equally good mower for less to give back to him, he might be a bit miffed. But with short selling your neighbour knows what’s happening, and he receives a fee for his trouble.

Of course things don’t always go as planned. The share price might rise instead of falling. But that’s not the concern of the lender, who just wants to get their share back later, plus the fee. And the lenders are the ones we’re concerned with here.

Do New Zealand managers of passive funds — otherwise known as index funds — lend their shares to short sellers?

I asked the following providers, which offer some passive funds: AMP, ASB, Booster, Lifestages, Simplicity and Smartshares. All but Smartshares replied that they don’t short lend on the index funds they manage themselves.

At Smartshares, the shares they lend “are protected by cash and other collateral (such as bonds or other easy to sell securities) which are valued at more than the loan,” says Hugh Stevens, CEO of Smartshares, which manages New Zealand’s largest range of 23 passive exchange traded funds. “Each loan is valued multiple times daily, and if there is a loss, then investors are indemnified by the agent, or the central clearing house.”

In other words, he says, “from an investor protection perspective, securities lending is one of the most secured transactions in the financial markets.”

Total lending by Smartshares is currently limited to the lower of 50 per cent of the value of the total portfolio, or 50 per cent of each individual holding, says Stevens. But most loans are made to allow settlement of ordinary share transactions. “This ‘failed trade coverage’ is needed when a broker is selling shares, but their own stock is temporarily unavailable, perhaps due to delay at their custodian.”

He adds that the market and investors can benefit from short-selling, “as short positions help to encourage faster price discovery and an efficient exchange of information. For example, if investors are expressing strong negative views in a company, perhaps for environmental, social or governance reasons.”

Beyond New Zealand, Graham Duston of Lifestages says “stock lending does occur with managers like Vanguard and Black Rock and their index funds.” Vanguard and Black Rock are huge international index fund managers. And the international portions of New Zealand-based index funds are often invested in their funds.

In the case of ASB, “underlying fund managers do not undertake securities lending for the accounts they manage for us,” says ASB general manager wealth Jonathan Beale. “ASB expressly prohibits this practice.”

However, this doesn’t apply to some other New Zealand-based index funds. So is it risky that these international fund managers lend their shares to short sellers?

No, says Sam Stubbs of Simplicity. Short selling is run by the big investment banks, such as Credit Suisse and Deutsche Bank. And the situation is similar to Smartshares’ situation in New Zealand. They borrow from fund managers, in exchange giving the fund managers collateral at least equal to the value of the shares, and then lend to short sellers.

If a short seller — typically a hedge fund — went broke, the investment bank is legally obliged to buy the shares to give back to the fund manager. If that failed to happen, the fund manager would keep the collateral.

Stubbs, who worked in this field for Goldman Sachs for five years in Europe and Asia, says “There were no failed short stock deliveries in the global financial crisis. I’ve never known a failed delivery. The penalties are quite severe. There are several layers of protection.”

Blackrock’s experience has been similar. “Since BlackRock’s lending program started in 1981, only three borrowers with active loans have defaulted. In each case, BlackRock was able to repurchase every security out on loan with the proceeds of the collateral received and without any losses to our clients,” the company says.

While Brian Gaynor said in his column that, “Active fund managers are much less likely to lend stock because they want full control of their holdings,” Stubbs disagrees. “Active funds do as much short selling as passive funds,” he says. This is partly because short sellers often want to deal with shares in smaller companies, which active managers are more likely to hold.

Responds Gaynor, who is an executive director of active fund manager Milford Asset Management, “Milford has never lent shares to short sellers, even though the NZX tried to get us to do so many years ago. I am not aware of NZ active managers lending shares to short sellers.”

Stubbs adds that even conservative super funds lend shares for short selling, as they benefit from the fees they receive. You could argue, he says, that fund managers that don’t do this aren’t fulfilling their fiduciary duty to maximise returns for their investors.

And so to your question about how risky this activity is. My reply: not very. I’m not moving out of index funds.

AI don’t think we need Commerce Commission intervention. The industry seems to be competitive. But it’s puzzling that commissions haven’t fallen over the years, given that they’re lower in other countries, as you say.

There are usually some newcomer agencies offering lower commissions, but they don’t seem to last — perhaps because people worry that the agents won’t do as well. But that’s not necessarily so.

I strongly recommend that if you’re thinking of listing your house, you read a recent article called Real Estate Fees on www.consumer.org.nz. You’ll have to join Consumer NZ, but it’s well worth belonging to. I use their research before I buy just about anything significant.

One of Consumer’s findings: “For the house in our mystery shop, which had a mid-range price of $720,000, fees ranged from 200 Square’s standard $4500 to $33,695 with Harcourts.” What an extraordinary range.

That’s a pity about your relative. It suggests everyone should try to do painting and superficial improvements themselves before selling.

AWe don’t know whether the correspondent took tax on gains into account before stating his profit. Still, he probably didn’t, so I should have mentioned it.

While profits from selling rental properties have for many years been taxable if you bought the property with the intention of selling it at a gain — which must surely be the usual scenario — the bright-line tests make it clearer.

It sounds as if last week’s correspondent bought the unit after October 2015. So if they sell within two years of the purchase date, the bright-line test will apply. Thanks for writing.

AYou’ve put the record straight, thanks. But, please, no more letters on who gets paid what.

All the best with your new career.