Pension funds’ stock lending in spotlight as hedge funds’ Carillion shorts pay off

Hedge funds the beneficiaries as infra firm shares nosedive

UK infrastructure firm Carillion, which saw its share price crash by more than 70% last week, was the most shorted stock on the FTSE 350 allowing hedge funds and other short sellers to rake in around £100m (€112m) on the stock, which was borrowed in large part from long-term investors such as pension funds.

Following a shock profit warning, a sharp increase in debt and larger than expected write-downs, Carillion, one of UK’s biggest contractors, saw its shares plunge from 192 pence on Monday last week to 55.45 pence on Thursday night.

Shares have recovered marginally after Carillion said on Friday that it had hired HSBC as joint financial adviser and corporate broker. Also bolstering the recovery was news of a range of contract wins for the beleaguered firm.

Data from IHS Markit showed that the percentage of shares out on loan for Carillion hit 29.6% on July 11; the maximum limit allowed on loan for any stock is 30%.

Short-sellers borrow stock from lenders such as pension funds and other long-only investors and bet on share prices falling, booking huge profits when prices drop.

Simon Colvin, research analyst at Markit, said the short interest in Carillion was over ten times the average seen across the index and had earned hedge funds roughly £100m last week alone.

He said: “Over the past few days as Carillion’s stock price tumbled, loan outstanding on the stock has risen to nearly 30%, which is the maximum level of shares that can be out on loan. Not surprisingly, short sellers have netted a huge payday from these recent developments.”

Long-term investors such as pension funds have come under strong criticism for their role in short-selling in which they lend shares to short-term punters such as hedge funds.

RI has highlighted this issue before, for example last year’s share price nosedive at Deutsche Bank. Investors such as Norges Bank have previously acknowledged the need to “balance” ownership voting rights with contributing to well-functioning markets via securities lending and the income it gets from the practice.

Many large pension funds such as the BT Pension Scheme and the Dutch pension fund giant ABP have closed down their securities lending programme. But with a squeeze on traditional sources of returns, pension funds have returned to stock lending in huge numbers.

Peter Wallach, director of pensions at the £7bn Merseyside Pensions Fund, said the fund – which has an active securities lending programme – also invests in hedge funds.

“It could be argued that there would be a contradiction in doing so and yet not being willing to stock lend.

“That being said, in our view, whilst there may appear to be a contradiction between long-term investment and securities lending, we believe the actual situation is more nuanced,” he said.Shorting, Wallach said, is sometimes undertaken for risk management purposes and securities lending is also carried out for reasons other than shorting such as to avoid trades failing to settle and for dividend arbitrage purposes.

“It is important that stock lending is managed responsibly”

Wallach said the pension fund also constantly monitored its lending and could restrict lending in stocks where they felt there may be damage from short selling.

And although the pension fund did not hold Carillion, it was “an excellent example of a situation where we would be intervening”, he said.

“Ultimately, it is important that any stock lending programme is managed responsibly and with due regard to potential issues around short selling,” he added.

One source at a large pension fund admitted that that stock lending was a problem, as there was no way of knowing who it would be loaned out to. Pension funds usually hire custodian banks and other intermediaries who in turn loan out securities to short sellers.

“We may be holding long positions on some of this stock which we loan out to short sellers – so there is a contradiction there as well,” the source added.

But other pension funds insisted that stock lending was an established part of the market dynamic.

Richard McIndoe, head of pensions of the £9.2bn Strathclyde Pension Fund, said that stock lending improved market liquidity and price discovery. He added: “There are all sorts of participants in that market, some with different objectives from us.

“Short-selling may create some market noise, but I don’t think it fundamentally disrupts our long-term investment programme.”

Joe Dabrowski, head of Governance & Investment at trade body the Pensions and Lifetimes Savings Association (PLSA), said pension fund trustees had a fiduciary duty to consider how they achieve value for money, represent members’ interests and to also ensure the best possible returns so that members’ benefits can be paid.

He said: “In an environment of low interest rates and volatile stock markets, pension schemes have been looking to diversify their investments to protect capital and deliver returns where possible.
“Stock-lending is another return-seeking approach, undertaken by some schemes directly but more often by their investment managers, either explicitly or implicitly.”

In May, the value of lending assets went past the $17trn mark for the first time ever, according to IHS Markit. An estimated 55% of inventory came from pension funds and mutual funds, Markit said.