The Short Seller As An Endangered Species - Should We Worry?
The author of this article claims that short-sellers resemble sharks as an endangered species. (People sometimes use the term "shark" about financial players for less flattering reasons.) He says that the decline in shorting is bad for liquidity, price discovery and efficiency. Markets are being pushed out of balance.
The short-seller is not a figure people typically warm to or celebrate. Governments have sometimes banned “shorting” (the practice of borrowing a security with the aim of selling it and repurchasing it at a lower price, and profiting from the difference). Amid the 2008 financial crash, governments such as those of Germany and the UK slapped limits on the technique. But overall they have left it alone. And with good reason: shorting allows market participants to act on a negative view of a security without taking the more drastic view of selling it for good. It arguably adds more players to a market and increases liquidity and price discovery. It compresses bid/offer spreads and reduces some of the frictional costs of the market.
In an age of massive central bank money creation (quantitative easing), a policy of “financial repression” designed to boost equities, how can short-selling be a viable tactic? Charlie White-Thomson, CEO, Saxo Markets, addresses that question and discusses other features of the shorting landscape. He gives a fascinating and brief tour of an aspect of markets that is not always as clearly understood as it should be. (This publication also intends to examine the role of derivatives, such as options, in portfolio management. Stay tuned.)
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Last week I read with a touch of nostalgia that York Capital announced that it would wind down its European hedge fund business to focus on longer-duration assets. This decision has been driven by lacklustre returns in some of their strategies. Credit Suisse is expected to take a $450 million hit on its investment in York Capital (see this report). In 2010, I was sitting in the equity trenches of Credit Suisse Moscow and clearly remember the internal announcements discussing this investment.
The list of such closures is growing and this follows on from the August announcement by Lansdowne Partners - that it is stopping short selling in its flagship £2.8 billion fund. Its statement, or part of it, alluded to the difficulties of selling short in this overstimulated market.
It encouraged me to think about the early 1990s and the launch of many short strategies, including Lansdowne Partners and York Capital. The Lansdowne Partners launch was led by fund managers out of the preeminent stable that was Mercury Asset Management. So many great names that are no more - SG Warburg, Morgan Grenfell, Barings Securities. All consumed by greater beasts in the food chain.
It is undoubtedly true that the life of a short seller in the face of gargantuan quantitative easing is a tough one. The liquidity pumped into the markets by central banks covers many sins and can make structurally poor companies with limited futures share prices perform well. Good and bad go up with the tide in this environment. The inflationary pressures are also significant but that is for another day.
At a time where a large number of investors seem to be thinking that the only way for stocks is up, short sellers like sharks help to keep things honest and their worlds on an even keel. They speed up nature and challenge the underperforming or weak. Assisted by their “amupllae of lorenzini” - or in the case of short sellers, corporate analysis - their aim is to find their prey or structurally challenged companies, and in doing so, restore faith in the markets.
A good example would be a company like Wirecard - where short sellers sold the shares above €100 and closed their positions when the share price had collapsed to €2, a view that has since been vindicated not merely on the value of the company, but also on its governance, something that short-sellers are often first to identify. Finding these companies is hard work and not without significant risk - by definition, the risk of being a short company is unlimited. This is partly why the regulators require hedge funds to declare short positions, with those thresholds becoming even more stringent during times of heightened market stress, such as during the current pandemic. Transparency is key and provides useful information to retail investors.
The list of short selling funds who have stepped back or closed is growing and this will harm the efficient functioning of the markets. The demise of short-sellers, many of whom are outspoken, larger than life characters who enjoy swimming against the tide and armed with conviction, is a shame and will make the markets a more dangerous place.
Short-selling is much more than about hedge funds. It is about the individual investor, avoiding groupthink, taking an active rather than passive approach to investing and risk management, using all the tools in one’s investment arsenal to generate the optimal balance of risk and return. We live in a world where the mantra is “long only” investing, tracker funds or buy and hold. Woe betide those who cloud the message of this religion or established order. There is an institutional lack of focus and education around short selling, as a valid strategy, either backed by conviction or as part of a market neutral long-short strategy. Phrases like “TINA” or “there is no alternative” when referring to the equity market should be a warning or message to the bravest investor.
Short selling is an important risk management tool and allows investors the opportunity to hedge their portfolio or to profit from declines in the market, if they believe that prices will fall. This should be a discipline that retail investors understand and have easy access to and not just the prerogative of the few.
It is worth noting that though painful and bruising, the closing of a trading strategy or fund, is nothing compared with the demise of those most majestic top predators - destined to swim constantly without rest, hunted remorselessly, trapped in nets and thrown back to the sea, or to have their fins hacked off for soup.
The World Wildlife Fund notes that with our oceans severely degraded, restoring sharks is key to improving the resilience of our waters. The same can be argued for our financial ecosystem, with the increasing absence of short sellers and access to the tools to go short, we risk financial markets turning into an echo chamber which lacks that all important balance of views and positions, and this, as history shows us, tends to end badly.