Short sellers target Canadian life insurers

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Here is a $2-billion question. Why do some investors hate Canada's big three life insurance companies so much they're selling them short?

A short sale is a high risk strategy because it exposes investors to unlimited losses if they're wrong. Even worse, anyone shorting has to pay dividends to the owners of the shares, so it's not a step to be taken on a whim.

Yet Manulife Financial is the most heavily shorted stock on the TSX, with more than 62 million shares sold in this way. Sun Life and Great-West Lifeco also rank high on the most-shorted list. As a group, the three life insurers, the best known companies in their industry in Canada, have a total short position on the TSX amounting to a tidy $2-billion worth of stock, a multibillion-dollar bet on their share prices sagging. There are also additional shares in the companies sold short in the U.S., but the amounts are not as large as in Canada.

Short-selling is the sale of a stock an investor doesn't own, in the hopes of profiting by buying it back later at a lower price to close out the transaction. The shares that are sold are borrowed through a friendly broker from another investor. Although it sounds complicated, short-selling is merely the reverse of the normal transaction of being "long" – or buying a stock in the expectation of making a profit when the share price goes up.

Given that short selling is a bet on a company slipping on a banana peel, the technique suffers from an image problem of not being a decent thing to do. It's the reason short sellers are typically a publicity-shy bunch. No investors have publicly claimed credit for the gargantuan anti-life insurance company bet, even though it has been a brilliant strategy in recent months.

Insurers' share prices were clobbered by last year's decline in interest rates, which made it harder for life insurance companies to earn high returns on their investments, the source of their profits.

"This short interest, this pessimism, is a reflection of the concern that interest rates, that bond yields, could go lower," observes Michael Goldberg, an analyst at Desjardins Capital Markets in Toronto.

One explanation for the trade is that some hedge funds are trying to goose their returns on the Canadian financial sector by simultaneously buying shares in banks, the strongest part of the financial system, and selling short the insurers, speculates Martin Braun, president of Adaly Investment Management Corp., a money management firm.

This approach – a kind of giant paired trade – was a definite money spinner in 2011, when the TSX bank index dropped a modest 2.9 per cent, while life insurance companies plunged 30.4 per cent.

Mr. Braun says the shorting may be targeting insurance as a sector, rather than making a judgment on the merits of individual companies.

The bet against the insurers is sizable, by international standards. Data Explorers published a screen last month of 66 global life insurers, and found two of the Canadian companies were among the most shorted in the world, based on how much of the stock was sold this way compared to the total amount outstanding.

Sun Life was tied for being the most heavily shorted, while Manulife was No. 5. In the case of Sun Life, 9 per cent of its stock has been sold short, while for Manulife it was 5 per cent. Data Explorers says the average in the sector is 2 per cent.

Shorting is an expensive proposition. Sun Life sports a 7-per-cent dividend, Great-West 5.5 per cent and Manulife 4.1 per cent, money that the shorts have to fork over to the owners of the shares they've borrowed. To be sure, those shorting can offset some of the cost of these dividends by using the proceeds of the sale to buy other high yielding stocks, such as the major banks, which pay out around 4 per cent.

Mr. Goldberg, for one, says interest rates will be the determining factor for the performance of insurance companies. If interest rates rise this year, which is his most likely scenario, "then those shorts are going to get their clock cleaned," he predicts.

Given the huge short position, there could also be an explosive rally in insurers' share prices if things turn out better for the industry, aided by short sellers themselves. That's because any sharp rally would pressure the shorts, and could force them to exit their positions by bidding for the stock, further fuelling any rally.

Selling them short

*as of Jan. 15. Source: Bloomberg, TSX Datalinx