From the desk of Roy Zimmerhansl,
Practice Lead, Pierpoint Financial
I am going to look at two linked issues that will affect the securities finance markets in the coming weeks and months. The first is news that hedge fund assets soar to all-time highs. The second is the removal of the short-selling ban in South Korea and the enablement of retail investors to short-sell for the first time.
Some key stats were released recently by Hedge Fund Research regarding asset flows for Q1 this year, and I suggest you read the full article for a broader range of stats by clicking here. Here are the figures that had an impact on me:
Total hedge fund Assets Under Management reached $3.8 trillion USD.
The growth was fueled by net investor inflows of $6.1 bn in Q1 ($22.1 bn over the past 9 months) and investment returns.
The total AUM increase was $201 bn from the beginning of Q3 2020.
There are now two strategy segments with over $1 trillion AUM – Equity funds and Event Driven.
All this of course is potentially quite bullish for the securities lending business, so all good, we can sit back and count on a bumper year. It seems to have started that way, with IHS Markit reporting a 15% YoY increase for revenues in Q1 2021 and 11% sequentially over Q4 2020. Easy-peasy.
Running a long/short fund is especially difficult in rising equity markets, yet the sector generated 26% returns last year. Returns come from market beta as a foundation, and outperformance is generated by managers with strong fundamental stock analysis – stock picking on both the long and short side. More money in these funds means more borrowing, but what are the current conditions like?
Following the lows in March, the ongoing ‘buy the dip’ mentality was likely to drive markets higher, and I expected last year that short positions would have been covered at a profit during the February and March falls. With that new baseline, I assumed it would be hard to find short candidates at then-lower prices. However, in our podcast last year with James Clunie, not long after the market bottom in March, James corrected my assumption, pointing out that despite prevailing conditions there were still opportunities for short positions and arguably conditions were even better. Listen to the podcast for more of his thinking on the point. We specifically talk about it starting at 17:45 into the episode.
But, a problem occurs when, as pointed out in this Laurence Fletcher FT article (subscription may be required), market prices haven’t been performing as expected over recent months. Perhaps due in part to the outsized impact of retail investors exemplified by GameStop and other meme stocks, the correlations between good/bad corporate news and their share price movements aren’t what they used to be. That makes it harder to do fundamental stock analysis, presenting further challenges for stock pickers. Coming to the “right” conclusion about a company’s prospects and taking a position based on that analysis but doing it too early can be the same as being wrong – especially for short positions.
This breakdown in patterns is also causing difficulties for computer-driven models. It will be interesting to see if this reduced-correlation period continues and if it does, what the impact will be on performance, and if performance turns negative, will funds be able to hold on to investor money.
On a more positive note, the funding of event-driven strategies is expected to provide opportunities. Event-driven funds look for opportunities arising from corporate events such as restructuring and M&A. While these don’t always create a need for borrowing, they do often enough that more money going into funds is a positive indicator.
Last year saw a new record in global convertible bond issuance. So far this year, they have continued to fly off the shelf, outpacing any other year since 1980 (when Refinitiv started tracking this info). Airbnb, Twitter, Spotify and Beyond Meat have all issued or announced issues already. Given the low-interest-rate environment and with equity markets climbing ever higher, these companies and others have raised CB debt with a zero-interest rate. This should continue to be good news for securities lenders.
In short, there are lots of potential positives, but there are also potential potholes along the way.
But what about South Korea?
I am not certain there is any market where securities lending gets discussed more by politicians. KIC, the Korean sovereign wealth fund, is both castigated for allowing its securities to fuel short-sellers and congratulated for generating returns for the benefit of the fund performance. This adds another dimension to the typical ongoing debate elsewhere amongst the ecosystem of stakeholders, from regulators to investors (long and short, institutional and retail) to governance advocates and more.
By the time you are reading this, the 14-month long short-selling ban in South Korea, to the delight of many, including securities lenders will be lifted. That market has been a huge contributor to revenues over the past decade and its absence during the ban has meant that returns diminished over time as trades ran off. The KOSPI 100 Korea has been in record-high territory since November 2020, which may be an indicator of the need for some prudent risk management through hedging. Korea has been a model for the growth of a holistic market until the lingering ban with cross-border activity on the long and short side and a vibrant domestic hedge fund community served by both Korean and non-Korean firms. The normalization of the market will present opportunities for many firms and result in a better-priced stock market with tighter spreads.
Despite the hefty lending revenues thrown off by Korea, according to Morgan Stanley, short selling accounts for 6 – 6.5% of turnover, compared to US and Japan where it can reach as high as 35-40%.
However, as noted earlier, maybe retail investors will have a say in future revenues. Since the start of the short-selling ban, retail investors have come to dominate the market, as the chart below shows. I am not certain whether the description of Korean retail investors as ’Ants’ is a pejorative, but it sure sounds like one to me.
Retail investing has flourished throughout Asia, mimicking the recent explosive growth of US retail investors. Retail investors, unlike institutional investors, take an individual approach. They are less concerned with comparing their returns to benchmark indices or their returns versus their peer group, meaning their behaviour is less predictable, challenging both computer-driven models as well as human stock pickers.
Retail investors in Korea will also be able to short shares for the first time after satisfying a minimal education requirement. The head of the Korea Stockholders Alliance said that retail investors were at a disadvantage when short selling as they don’t have the same information as institutional short sellers. While I agree, the same statement applies to the long side as well, although I am the first to say short selling carries more risk than long investing.
Add on top of this that many of the Ants have used borrowed money to go long, and you can see why the FT says “South Korea’s retail investor army declares war on short-sellers”. The borrow and buy strategy has worked pretty well as the chart below shows. For a quick snapshot of what happened on day 1 of short selling, go to https://bloom.bg/3ue8Woh. What you will see are familiar names from before the ban was implemented and have had big price rises in the interim. In other words, some stock pickers still believe these stocks are over-priced.
My concern with Korea is that if there is a market downturn, leveraged losses will be exaggerated for voters [editor: Oops] retail investors, the short sellers will inevitably be blamed and who knows where that might lead.
What’s my point? My view is that by some counts we’ve had a good start to the year. The forward-looking signs are good overall - GC hedging for rising markets; hedge funds have more money to play with in strategies that often require borrowing; and Korea is BACK!
The clouds in the sky are political/regulatory and influenced heavily by retail investors.
It should be fun.
PS This past week we re-started our weekly #SecuritiesLendingLive with Pierpoint on LinkedIn Wednesdays at 10 am BST. Last Saturday we added a half hour “Ask Me Anything” on securities lending on Saturdays on our YouTube channel at 1 pm BST.