Indirect Effects of Indirect Investment

I can’t say enough about index investing.  The best, perhaps only, free lunch in investing is diversification.  And index funds are superb instruments with which to achieve diversification.  There is, however, a potential dark side.   Don’t worry, this dark side won’t effect you much… not really.  At least not directly.

What has me a bit worried is “giving up the vote.”   Yup, when you buy shares of an EFT, mutual fund, other fund you forfeit your voting rights to the underlying shares.  Say you own 1000 shares of SPY.  Cool.  That means you own a couple shares of Apple and a handful of XOM shares.  But, guess what?  You can’t vote them!

Do I care that I am giving up my votes to iShares?  Not enough not to buy ETFs.  But I care a little bit.  Enough to mention it in my finance blog.

The term “indirect investment” is not precise because saying “direct investment in stock” is perhaps not technically correct.  Nonetheless, I am slightly annoyed at institutions voting my shares.  I’d rather these shares not get voted… so that direct shareholders would not get overridden by institutional votes.  Better yet, I’d like to be able to set some parameters for how my shares should get voted.  Difficult to implement… but I’d like it.

So while index ETFs are the best thing since sliced bread, finding a solution to shareholder disenfranchisement would be a welcome improvement.

From the Financial Toolkit: Short Selling

In the previous blog post I wrote about the mechanics of options to help smooth out and reshape investment volatility.  In this blog post I want to discuss another investment tool:  short selling.

Short selling involves borrowing shares of stock and selling those borrowed shares.  This immediately does two things to your portfolio:  1) It gives you a liability for the shares, 2) It gives cash proceeds from the sale.

An investor, Alice, may choose to short a stock (or ETF) because she expects its price to fall.   She may expect one security  to fall relative to another security.  For instance, if Alice expects AAPL to outperform MSFT over then next six months, she could short MSFT and use the cash proceeds to purchase AAPL.  Even if MSFT goes up, Alice will make money so long as the value of her AAPL holdings go up more.

Suppose things don’t go according to plan for Alice.  For some crazy reason MSFT shares go way up, while AAPL shares remain flat.  As this trend continues, Alice’s portfolio net asset value (NAV) erodes.  This decreases Alice’s margin and increases her portfolios’ leverage.  If the trend continues Alice will eventually receive a margin call and have to cover her short position by buying MSFT stock to close her short position.

There are a few details to be aware of before entering a short position on a security.  The first is determining whether (and how much) stock is currently available for short-sale.  Once you’ve determined that your chosen stock is available for shorting, you should find out the particular terms for borrowing the stock.  For instance, you may forfeit a small percentage of your short-sale proceeds.  Often highly liquid stocks will be cheaper to borrow than less liquid ones.

Once you’ve found an stock with short-availability and an acceptable borrowing rate, you can execute a short-sale.  Since you will have a negative position (say -100 shares) you will pay rather than receive dividends on every share.  See also this helpful explanation of how, where, and why short-shares become available.

That’s the basics of short-selling.  Short-selling provides an alternative way to bet against a stock.  Buying puts is one method, short-selling is another.   Short-selling is allows going long-short… picking winners AND losers.  Short-selling is a tool that opens many investing opportunities and exposure to additional investing risks.