The Value of Shorts in a Responsible Investment Strategy

GameStop. It’s hard to imagine a more perfect name, and metaphor, for a company used by wallstreetbets, the subreddit group, to “game” the financial system and make a run at “fortress Wall Street”. This community of traders drove up GameStop’s stock price, not primarily out of a sentimental love for this brick-and-mortar retailer, but most notably as a means to “stick it to the man”, i.e., to punish big-name hedge funds that had shorted the stock.

Big “Finfluencers” like Elon Musk even got involved, expressing support for GameStop and wallstreetbets’ efforts. With nonstop media coverage, Main Street’s interest was piqued. The desire to participate in the windfall had everyone from grandmothers to members of Gen Z asking the question: what is a short?

While the frenzy over GameStop has now subsided, we believe there will be lasting effects. Treasury Secretary Janet Yellin is holding meetings with regulators to discuss the stability of the financial markets in the face of so-called “meme stocks.” Senator Elizabeth Warren is raising flags about the potential erosion of investor confidence in the overall financial system. And revived concerns about democratizing the markets to create equal opportunities for the individual investor has caught the attention of Congress in both the Senate and the House. Perceived as a populist issue, it has attracted conservatives and progressives alike.

In the aftermath of this event, shorting, while an established function of the financial markets for many years, may also go under the microscope.

In our current environment, shorting, which is a bet that a stock price is going to go down, can be interpreted as the means to destroy what was once a good business to make money for a select few. In the context of a long-short hedge fund, shorts can be viewed as vehicles to make money for Wall Street’s so-called “fat cats” at the expense of everyday employees who lose their jobs.

Shorts for Good

I’m not here to defend hedge funds or their use of shorts–far from it. I find the “money at all cost” culture of many hedge funds to be the antithesis of ESG and socially responsible investing practices. Yet not all shorts are put on with the same purpose, and we at FFI Advisors offer a perspective that shorting companies with negative practices, from an ESG standpoint, is a valuable tool that investors can use to build better portfolios and to effect positive environmental and social change.

In simple terms, I believe that shorting “bad” ESG companies is simply an extension of divestment principles. Let’s take the experience with fossil fuel divestment as an example. The graph below charts the performance of the S&P 500 versus a fossil-fuel-divested version of the same. Clearly, excluding “bad” ESG companies has generated superior financial returns, even over longer term periods.

So if excluding companies that harm the environment has proven to be of financial benefit, why not go one step further and short these companies? Certainly, some ESG investors are worried about having these companies appear among their holdings, even as shorts. There is also a legitimate concern about the risks of short squeezes, where an investor may have to buy a stock back in order to settle the borrow. Yet these reasons simply do not justify not shorting companies with poor records from an ESG perspective. Shorting such companies can serve different purposes in a portfolio for ESG and socially responsible investors.

First, it is a way to generate returns from the ultimate decline of companies that harm the environment. The massive disruption of the energy markets is  underway, and it is now just a matter of when, not if, the energy and transportation systems will become green. Excluding fossil fuels from a portfolio can help an investor avoid that risk, but shorting can enhance the portfolio even further by positioning the investor to profit from the decline of the sector.

Second, short positions, even though intended to generate alpha, can provide for a reduction in overall exposure to equity markets. In other words, short positions can provide a natural hedge as markets experience broad sell-offs, or general “risk-off” sentiment that impacts all sectors. (e.g., financial crisis, COVID).

Finally, while short positions don’t provide investors with ownership interest, they often do have influence on corporate behavior.  Shorting has long been an effective way to put companies on notice about the need to improve their performance. For socially responsible and impact investors, similar to divestment, it can be used as a direct way to penalize companies for harmful business practices (such as exploring for and producing fossil fuels, which must be stopped in order to achieve net zero emissions by 2050).  

The Anti-Hedge Fund

I’ve never been comfortable characterizing FFI Advisors’ Energy Transition Long-Short fund as a hedge fund. The culture of greed ascribed to hedge funds (perhaps with too broad a brush) is the opposite of what we strive to be.  We are a sustainable investment firm that uses long-short strategies to generate performance and support investors who seek to make sustainable investments. It is through “long” investing that we look to reward companies focused on clean energy renewables and energy storage that are critical to the energy transition. Conversely, it is through “shorts” that we choose to deny companies, especially fossil fuels with deep carbon footprints, the social license to continue to harm the planet.

The GameStop event may very well turn out to be a market aberration, which has since been corrected. But it is just as likely to be part of a bigger societal trend to reform Wall Street.

For this, we welcome that examination of the markets and we embrace the need for system stability. We are also proponents of financial inclusion to create an even-playing field for all. But equally, we continue to see shorting as a both a message and mechanism to halt the behavior of bad agents. For this reason, we believe responsible shorting has a meaningful place and critical purpose in the evolution of sustainable, climate-aligned investing.