Short selling has been hogging the headlines lately, fueled by a war between retail investors and several high-profile hedge funds over GameStop shares. Encouraged by Reddit’s popular WallStreetBets forum, this war had retail investors targeting short sellers of GameStop shares. The resulting ‘short squeeze’ saw extraordinary price movements (up 1,625% over January 2021) and a renewed debate around the role short sellers play in the financial system.
So, the question is, do short sellers really play a useful role in markets? And what are the possible consequences for short selling following recent events?
Why does short selling exist?
Put simply, short selling is where an investor sells an asset that they have borrowed from another investor. There are many reasons for doing this (see below), but the main reason (and the reason the hedge funds involved in the GameStop saga did) is a belief that the asset is overvalued and/or the price is likely to fall in the short term.
So, in effect, short sellers are making money from the losses of others, hence the negative rep it often attracts. Despite this, we believe that (in general) short selling is a good thing as it helps markets run more smoothly – here’s why:
Price discovery
One of the strongest arguments in favour of short selling is the positive impact it appears to have on ‘price discovery’ – that is, in helping the market to determine the ‘correct’ or ‘optimum’ price in terms of capital allocation and smooth-running markets. This is clearest when an asset price is thought by some investors to be widely overvalued or in a bubble. By allowing short selling, the market can incorporate this information into current prices, which may then provide useful information for other investors. This additional information should (in theory) provide more efficient market pricing.
Some evidence to support this theory can be seen in assets where short selling is not possible (such as residential housing), since these are more likely to experience bubble-like phenomena. This idea is further supported by academic studies, which imply that the allowance of short selling seems to lead to larger, better functioning markets, with lower capital costs and fewer price crashes.
Identifying fraud/malfeasance
Another strong argument comes from the potential of short sellers to discover fraud or misconduct at targeted companies, especially regarding accounting issues. There have been some high profile examples of this recently, including Wirecard (where short sellers helped to uncover a c.€1.9B hole in their balance sheet, leading to the firm’s collapse) and Nikola (an electric truck start-up, where short sellers’ allegations caused the resignation of the firm’s founder and collapse in the share price). By providing a financial incentive to root out potential misconduct, short selling can help clean up markets and uncover corporate/accounting fraud (some of which have been missed by auditors).
Engagement
A new area where institutional investors can benefit from short selling is via company engagement. Through short selling, investors can arguably send a stronger signal to management about their behavior than could be achieved by merely excluding them from their investments. This is particularly relevant given the growing importance of responsible investing. For example, investors could short sell high carbon intensive companies, signaling to management a (negative) view of their business model. The act of short selling could also indirectly help investors achieve their ESG objective by (for example) raising capital costs and thus making it harder for the companies to operate.
Risk management
As well as helping investors better manage portfolio risk (by enabling them to hedge their positions), short selling also allows for the creation of new investment strategies with diversified sources of return. For example, relative value strategies use short selling to minimise their exposure to the broader market.
Short selling can also have a positive impact on market infrastructure through the creation of liquidity, lowering bid-ask spreads and, hence, transaction costs for other investors.
The underlying investors
While short sellers tend to be larger, more sophisticated investors (mainly due to the increased risk and expertise needed to successfully sell assets short and other barriers such as collateral requirements), more often than not, they manage the money of fairly typical institutional investors such as pension funds and endowments. A point missed by many advocates of the recent GameStop incident.
Although our overall view of short selling is positive, there are some legitimate objections worth exploring:
Market manipulation
Some short sellers are (in)famous for producing scathing reports of companies. This can be done with or without a corresponding short position in the company. We mentioned earlier the potential positive effects these reports can have on identifying fraud and misconduct, however, there is also the possibility of false accusations being made in order to profit from any subsequent falls in share price. Although this issue also applies to long positions (and falls more generally under the scope of market manipulation), the potential upside is likely to be far greater for short sales.
Negative side-effects
When buying shares in a company (going long), investors have a financial incentive to increase the share price. They may try to do this by offering strategic advice to management, supplying additional funding or providing good public relations for the company. These additional actions may have positive side-effects (e.g. if the company becomes more efficiently run as a result). However, if an investor has a short position in the company, the incentives are reversed, and the investor now has a financial interest in ‘seeing the company fail’. They may act on these incentives by (for example) making negative comments about the company and disrupting management. This could result in negative side-effects for stakeholders such as employees, suppliers or customers.
Market dynamics and volatility
Short selling may cause additional volatility, at least in the short term, which is what happened with the recent GameStop short squeeze. When investors identify that an asset has been heavily shorted, they buy that asset in an attempt to force the price higher. Once the price reaches a certain level, the short seller will be forced to buy back the share (due to collateral requirements, or minimising their losses), causing the price to rise further. The resulting feedback loop can cause huge price increases and heightened market volatility and will inevitably lead to substantial losses for those unlucky investors caught in the crossfire.
What are the possible long–term impacts of recent events?
Will recent events and a renewed hostility towards short selling have a long-term impact on the investing environment? It’s too soon to say for sure. However, there are two areas we think are worth keeping an eye on:
- The ability for active managers to outperform using short strategies
The events of recent weeks have had a large and immediate impact on some investment strategies involving short selling. One prominent research firm has announced it will no longer publish reports detailing short selling opportunities. There has also been a broad pullback from short positions amid fears that short-based strategies may be targeted by retail investors. This may influence whether investors commit to these strategies in the future, particularly those involving high profile targets. - Unexpected consequences for the investing environment
If this shift is permanent, it may negate some of the positive market influences we detailed above around pricing, market efficiencies and transaction costs. It may be harder for investors to balance the risks in their portfolios and for the market to fully incorporate the views of all investors.
There is also the possibility that regulators take a more skeptical view around short selling, possibly putting restrictions on how and when it can be carried out.
Conclusion
Although short selling has its risks, such as the potential for market manipulation, a misalignment in incentives and the potential for increased volatility, we believe it is an important part of the investing landscape, helping to ensure more responsive pricing, identify fraud, provide diversified sources of return and a way for investors to engage with companies. While recent events have shone a light on the dangers of short selling, our belief is that it provides a myriad of benefits and, provided investors are aware of the potential downsides, should continue to be permitted and practiced in its current form.
