A Short Story

(not Charlton related)

Last week as outright panic characterised the world's financial markets, the public and its media were on the lookout for a handy scapegoat.

Strangely opting to overlook the wanton negligence of management teams and their regulators, attention instead focused on the 'spivs and speculators' otherwise known as short-sellers.

I've met many of these people and trust me, you'd be delighted if your daughter brought one of them home, especially the one that made $1.7billion last year I suspect. One of the media's favourite targets is so polite and softly-spoken, you'd easily mistake him for an altar boy (except that he's Jewish). Speculators for sure, but definitely no spivs.

Short-selling is a way of betting upon the fall in price of a security (typically a stock), usually undertaken by hedge funds but also by more sophisticated individual investors. The short-seller borrows the stock (in order to fulfil the sell order), and hopes to be able to buy it back at a lower price, return it to the lender, and profit from the difference.

The vast majority of short-selling is not undertaken with the intention of driving a company into the ground (some management teams are more than able to do this themselves). There are hardly any funds that solely short stocks because it is so extraordinarily risky (see below), although you wouldn't know it from the headlines.

Instead by building a diverse portfolio comprising traditional 'long' positions, as well as 'short' positions, an investor can reduce his correlation to overall market movements, and hopefully generate positive returns in different types of environments, particularly bear markets. There are no guarantees of course as many failed funds have discovered.

Some very successful hedge fund managers with long-term records have lost money overall through 'shorting', including some of those so vilified in the media this week. They welcome however the reduction in volatility that their short positions offer them during market sell-offs.

Interestingly various 'hedged' products have been launched recently, aimed squarely at the very same retail investor that the media would have us believe is the victim of such activities.

In an exuberant bull market such as those of 1999 or 2003, the short-seller would typically not even expect the stocks he is 'short' to fall, but would hope they would simply not rise as much as his 'longs'.

As it transpired however, particularly during the tail-end of the technology bubble of the 1990s, most outright short-sellers went out of business as the ridiculous valuations of Internet companies spiralled even higher (before they eventually did collapse, albeit too late).

Short-selling is very far from a one-way bet. Indeed it is so risky that most brokers will not permit its clients to undertake it unless they can demonstrate above-average financial sophistication and resources. Here are some examples why:

1. The maximum loss on a 'long' position is 100%, and the maximum return is infinite. The maximum loss on a short position is infinite, but the maximum return is only 100% (at best, the stock can only go to zero).

2. When a long position begins to move against an investor, it becomes a smaller problem. When a short position begins to move against an investor, it becomes a bigger problem.

For example, if an investor with a £1million portfolio buys £50,000 of Vodafone and it halves in price, then all other things being equal, his original 5% position is now an approx 2.5% position. The investor has less money of course, but his exposure to Vodafone is relatively lower too and he can sleep soundly.

However if an investor had sold short £50,000 of Vodafone and it doubles in price, the investor's risk has doubled too (the investor now owes £100,000 worth of stock). For this very reason, sensible investors build far smaller initial short positions than long positions. Thus not only can an investor make no more than 100% on any given short position (see 1.), he will likely have taken a smaller bet to begin with.

3. Stock prices usually go up (although it's a timely reminder in the current environment). The short-seller is not only battling the mathematical biases explained in points 1. and 2., but he is also battling the inherent ability of companies to make profits, the fuel of capitalism.

4. In the absence of leverage, a long investor cannot be 'forced' out of any of his positions. A short-seller meanwhile is using leverage by definition (he is borrowing stock), whilst the lender can typically demand back that stock without reason or notice.

Although it's thus risky and best left to experts, the short-seller provides a vital market role in enhancing market liquidity and efficiency. In a rising market, the short-seller dampens riotous enthusiasm by acting as a rare seller of stock.

In a falling market, the short-seller will be closing out his (profitable) positions by buying back the stocks he has borrowed, thus acting as a rare and welcome buyer. As a result, markets are likely less volatile and stock prices more reflective of fundamentals than sentiment, thanks to short-sellers.

The case of those financial stocks which were headline news last week do perhaps warrant some special treatment in such extraordinary times, although plenty of regulations already existed to prevent the worst excesses. For example, the spreading of (knowingly) false rumours has always been illegal, and rightly so.

The enormous leverage inherent in financial companies, makes them unusually vulnerable to a sudden collapse in their share price. But this leverage had clearly become excessive, funding increasingly crappy assets with increasingly short-term liabilities. This should never have been allowed to happen (by the regulators) , but it did happen and the short-sellers rightly suspected the true equity value might be zero for them too.

Yet as the share price falls, eventually it reaches a point where the risk/reward of remaining short worsens, whilst fundamental 'long' investors might be tempted in. On Wednesday afternoon for example, investors were offered the chance to buy shares in Goldman Sachs, the world's premier investment bank, at just five times earnings. or $98. As enticing a proposition for a long investor, as it was dicey for a short-seller (the stock closed on Friday at $130).

It is important to note that the share prices of Bear Stearns, Lehman Brothers, Northern Rock or HBOS did not collapse by virtue of 'spivs and speculators'. They collapsed through chronic mismanagment, and bets on rising house prices, all of which were lost. Each management team had opportunities to sell the business or at least reduce its risks, yet hubris told them to push on.

Short-sellers are absolutely entitled to signal to the market that the chronic asset/liability mismatch that each of the above demonstrated, was not yet reflected in its share price. Other better-run banks or those with more sustainable business models (eg. HSBC, Lloyds TSB, JP Morgan Chase) have not faced any discernable pressure from short-sellers at all. As I mentioned above, a handy scapegoat, but the wrong one.

In 2007, the US regulators removed something called the 'uptick rule' which would have prevented most of the problems observed last week. It required all short sales to be undertaken at a price higher than the price of the most recent trade, thus preventing short-sellers from adding to the downward momentum of a stock already experiencing price declines.

The reinstatement of the 'uptick rule' would seem a balanced and welcome response to some of the emotionally-fuelled nonsense written in recent days. Expect to read more about it.