By Jack Inglis, CEO, Alternative Investment Management Association (AIMA)
Short-selling hit the headlines again last week after the New York Stock Exchange’s Group President, Thomas W. Farley, described the practice as “icky” and “un-American”.
Going after short-sellers is a recurring, historic theme. Mr. Farley didn’t say he wanted to ban the practice but that it left him feeling uneasy.
I don’t want to knock Mr. Farley or second-guess how he intended his point to come across. The reality is that some people do think short-selling amounts to betting on a company’s failure. That it is somehow mean-spirited. Why, critics say, would you want to take a shot at a company that’s trying to make a profit for its employees and shareholders? Can’t the short-sellers just cut it out?
This misses the point of short selling. For most asset managers, it is an essential risk management tool; a tool that investment managers use to protect their investors’ money and limit the risk of losses. It gives investors flexibility, diversifies their income streams and is a smart way for them to express a sentiment other than “everything’s going up”.
Let’s say I like a few stocks in a particular sector and invest in them. If I spot that another stock is overvalued relative to shares of the other companies in the sector that I’m invested in, I can assume that its price is likely to fall more sharply than that of its peers in a downturn. And I can use that analysis to protect my investors by shorting the stock. It’s hedging and it’s not manipulative: I’m just making sure that my investors don’t experience a bumpy stock market ride. The company I short can be perfectly well-run, it’s just that it may be overpriced.
Ultimately the reality is that markets are inefficient. Sometimes securities are mispriced. And that’s precisely why investors hire asset managers – to root out those inefficiencies and translate them into profit. If their analysis is right, they make a profit. And if they call it wrong, they lose out. Doing it right takes skill and expertise and is fundamental to a healthy financial market.
Also, think about what would happen in a market where you have long position-holders only. Prices will tend to keep going up. What happens when you have investors who can potentially make a profit by saying, “hang on a minute, this company has not got its act together”? Bubbles are less likely. Capital is more likely to flow to the firms that can use it productively to grow their business.
Sometimes short-sellers even help to blow the lid off corporate fraud, Enron being the ultimate case in point. Some of the first people to have spotted that the energy giant was coming off the rails in a big way were short-sellers. There are countless other examples.
So short-selling is neither icky nor un-American. It represents the essence of what capital markets are for – a meeting place of people with different viewpoints who express those viewpoints by buying and selling securities. It fuels the process of price formation.
Part of Mr. Farley’s point was that there should be greater transparency regarding firms’ short positions. We don’t disagree, but the devil is in the detail. If regulators need that data to assess risks of market abuse or systemic problems – after all, at times shorting can be comparable to an early warning system, a canary in a coal mine – then that is fine.
But disclosing short positions to the public is a different matter. Research has shown that such disclosure dampens buying and selling of stocks and undermines the aforementioned benefits to markets and investors. Asset managers’ views can be copied, creating disincentives to carrying out research or innovating, and they can be refused access to issuers’ senior management even it is unclear if they ultimately intend to buy or short the stock. This can distort trading activity and lead to the misallocation of capital. Policymakers need to think long and hard before changing the existing rules, otherwise there’s a real risk of harm to capital markets.
Jack Inglis became the chief Executive Officer of AIMA in February 2014. He has been involved with hedge funds for 25 years and has held leadership positions in prime brokerage at both Morgan Stanley, where he served for 16 years, and Barclays, where he was prior to joining AIMA.
From 2007 to 2010 he was CEO at the convertible bond specialist, Ferox Capital Management. He began his career in 1983 and has extensive experience across origination, distribution and trading across the capital markets. He holds a Master of Arts in Economics from Cambridge University.