By the way, a fun model of passive investors and short sellers would be something like “all index funds lend out all of their shares to short sellers, all the time, and all shares sold short are borrowed from index funds.” This is not, of course, true: Not all index investors lend out their shares, plenty of non-index investors lend out their shares, and anyway most companies don’t have all that much short interest, so even if index funds were willing to lend out all of their shares they probably wouldn’t be able to. But it is, you know, vaguely in the direction of true; more index funds lend out more of their shares, etc., and if you are shorting a stock there is at least a decent chance you’re borrowing that stock from an index fund. “All index-fund-held shares are sold short and all short shares are borrowed from index funds” is not accurate, but it is a nice thought experiment, an extreme and sharpened form of some trends that are true.
What would be the implications if it was true? We talked about one last month. People worry sometimes about the concentrated voting power that index funds have over public companies; when a company’s largest shareholders are big index-fund firms, what does that mean for corporate stewardship and competition and so forth? But in my thought experiment these issues are just fake: Index funds own a lot of shares, but they don’t get to vote them, because they lend them all out to short sellers and the votes travel with the shares. (Index funds own shares, which they lend to short sellers, which the short sellers sell to active non-lending long investors, who get to vote.) Again this is not quite true, but it is not entirely untrue either, and the voting power of index funds—and its implications for corporate governance and the environment and the world generally—is probably overstated because people forget that index funds lend out a lot of their shares.
But you could extend that logic. People worry about the impact of index funds on price discovery: If index funds have to just buy all the stocks, aren’t they contributing to bubbles or erasing the price difference between good and bad companies or affecting volatility or otherwise undermining market efficiency? But in my thought experiment the answer is no: The same amount of price discovery goes on, because the index funds lend their shares to short sellers who have active (negative) views on the stock, and who sell those shares to long investors who have active (positive) views. [...]
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