Short-selling: financial weapon of mass destruction or important risk management tool?

The GameStop drama in the first quarter of this year put short-selling on the front page, generating column inches about the practice not seen since the Global Financial Crisis of 2008, when Dick Fuld, then CEO of the failing investment bank Lehman Brothers, famously blamed “the shorts” on the collapse of Lehman’s share price, and when regulators around the world instituted bans on short-selling.

Some of the notable headlines about short-selling during the GameStop affair included “Wall Street short-sellers are in retreat after the GameStop short squeeze”; “Short sellers still love to hate GameStop”, “Short sellers burned as small investors pile into GameStop” and “These short-sellers are making a killing in defiance of GameStop’s retail army”.

To recap the GameStop affair, the firm was a “brick and mortar” video game retailer that was widely thought to be facing Blockbuster-style oblivion as its core business model based on physical retail outlets was being disrupted by online gaming and the Covid-19 pandemic. Investors were understandably skeptical about the long-term prospects of the company, and some hedge funds had taken short positions in it.

At the beginning of 2021, its stock was trading below $20. By the end of January however, the stock had soared, at one point nearly touching the dizzying heights of $500 before plummeting again and subsequently rallying.

The narrative in the media was that a Main Street revolt had taken place that pitted retail investors against “Wall Street” hedge fund short-sellers. In online discussion forums, the retail investors blamed the woes of GameStop on hedge funds that had taken short positions in the stock and vowed to squeeze them out of their position by driving the price higher.

They succeeded in this, with several prominent hedge funds incurring big losses, much to the delight of posters on Reddit’s “wallstreetbets” forum. Many public commentators savored what was seen as a victory of Main Street over Wall Street – a David vs. Goliath story, with hedge fund short-sellers succumbing to defeat.

However, like many narratives, this one was not wholly accurate. It transpired that far from being a binary battle of retail vs. hedge funds, it was a lot more complex than that. GameStop’s ascent was driven by other hedge funds and by institutional money as well as by retail. Retail investors were not only buying the stock, but selling it too. In other words, hedge funds and retail were both on each side of the trade.

Indeed, Matt Levine of Bloomberg analyzed the Citadel Securities data during the key week at the end of January and found that 49.8% of retail orders were to buy, and 50.2% were to sell. His column concluded that the real price action was coming from the professionals, quoting one observer who said, “past the retail ignition, the rocket ship was mostly intra-fast money warfare.”

Lawsuits, federal probes and congressional hearings have taken much of the gloss off the victory of those who orchestrated the short squeeze, with some commentators arguing that the collective activity amounted to market manipulation.

For our part, as allocators, we think that the way in which hedge fund short-sellers were portrayed as the villains in this episode was inaccurate. Far from shorting being a sort of financial weapon of mass destruction, we believe it can be an important risk management tool for investment managers. In fact, we would argue that the practice can be justified on broader grounds too, in terms of the constructive role it can play in capital markets and therefore in the efficient allocation of capital for the real economy.

Ultimately, short-sellers are in the business of finding out the truth about companies. A recent paper by the Alternative Investment Management Association (AIMA), the global hedge fund industry organization, argued that “short sellers have an incentive to discover the flaws in a company; an incentive that long-only managers do not possess to the same degree.”

Indeed, it may be argued that short-sellers are the only market participants who are incentivized to find out the whole truth in this way. Listed companies incentivize their CEOs to boost their stock prices, and many of the other market participants including brokers and advisers have an interest in prices rising, creating powerful forces of hype that can mislead markets. The short-sellers are the only ones incentivized to declare that the emperor is not wearing any clothes.

This is desirable because it helps to root out fraud in public companies. For example, the collapse of the German payments company Wirecard last year was facilitated by forensic research carried out by short-sellers. Enron, one of the most spectacular corporate frauds, was also identified by short-sellers. Dick Fuld may have railed against the shorts as Lehman’s price collapsed, but they were not to blame for the fundamental weaknesses of his bank that was leveraged up to 50 times at its peak.

The ability to short is also important for efficient portfolio management. A portfolio that is both long and short is not necessarily going to be down when the markets are and can manage risk more effectively than a long-only portfolio. This is important for long-term pools of institutional capital such as pensions, endowments, insurance companies and sovereign wealth funds, and helps to explain why these pools of capital continue to invest in hedge funds.

It appears that regulators internationally now recognize the value of short-selling. According to the AIMA paper, the cumulative length of time of short selling bans in major jurisdictions has declined from nearly 4,500 days during the Global Financial Crisis in 2008-09 to under 500 days during the Covid-19 market turmoil last year.

Short-selling will always attract controversy, not least from failing companies, but the reality is that there is a growing consensus among policymakers and regulators globally that the practice is of value to markets, to investors, and to the real economy.