So short sellers are still the public bêtes noirs of the equity market. That would appear to be the message conveyed yet again in February and March as US regulators prepared to brief William Donaldson, the new head of the Securities and Exchange Commission, on some of their plans to sort out this particular trading strategy.
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Donaldson: many are expecting |
It coincided with the announcement from the SEC at the end of February that it had fined Rhino Advisors, an investment advisory firm, $1 million for spearheading what it dubbed a “death-spiral campaign” using short selling to drive down the shares of Sedona, a software company.
Blaming short sellers for the poor performance of the stock market is hardly new, but there doesn’t appear to be any evidence that short selling by itself is as nefarious as its detractors claim.
For one thing, short sellers make up a very small part of the hedge fund world. Dedicated short selling funds account for just 0.11% of hedge fund assets under management, according to Alexander Ineichen, managing director and equity derivatives analyst for UBS Warburg, who last summer wrote Peaches, lemons and sour grapes, a seminal report defending short selling. “Two of the largest styles, equity hedge and equity non-hedge, make up 42.5% of the asset pool, and they ought to be net long equity if they are adhering to their mandates.” Which they probably were, as they suffered losses in the June rout, he pointed out.
But for many detractors, evidence isn’t important, says Neal Berger, president of Aquila Capital Partners, a New York-based multi-strategy hedge fund. He says: “For some reason the world thinks it’s more politically correct to make money from long investing than from shorting.” In fact, there’s plenty of evidence to prove that short selling is in fact good for stocks.
Shorting is good for you Astec Consulting tracks short selling trends, and in a recent study of last summer’s precipitous US stock market decline, showed that dedicated short sellers appeared to have stabilized the market.
The report distinguishes between fundamental short sellers and arbitrageurs, which conduct trades “paired off against stock purchases, short-term positions taken to facilitate trading activity and taken as the response to a merger”.
These arbitrage trades are not so useful for determining whether short sellers are moving markets. A more relevant approach would be to establish a ratio between short interest – the volume of shares sold which are still open in broker accounts – and short sales. “Short interest rises most relative to short sales when fundamental short sellers are active,” Astec says in its report.
Astec then applies this to the period between May 17 and July 23, when the Dow dropped from 10,300 points to 7,700. The ratio, which Astec calls the fundamental short ratio, jumped 25% during that period, as short sales rose by 31% but short interest only increased 5%. Astec says: “This suggests that the new shorts were being generated by arbitrageurs, while fundamental short sellers were seeking to lock in profits.”
In other words, long funds were trying to hedge their positions by shorting, while dedicated short sellers were going into the market to close their shorts by buying the underlying stock. And that helped to provide some stability. “Short selling dampens market volatility,” says Berger. “It adds a buffer, without which there’d be a snowball effect because in a down market everyone would be wrong, everyone’s stop-losses would be triggered, and everyone would try to sell.”
Dedicated short sellers, according to the report, were covering their positions from the middle of July, before the Dow hit its lows, until mid-August when the Dow rebounded to 9,053 points.
The fall was therefore not caused, or even exacerbated, by professional short sellers. The real cuplrits are obvious: corporate malfeasance hit investor confidence, making people pull money out of equity funds. Retail investors, according to Trimtabs, pulled out over $70 billion in June and July from US mutual funds. Many funds would have had to sell stocks to be able to return that cash. Insurance companies would also have been forced to sell, says Ineichen: “As interest rates have fallen, so the value of insurance companies’ liabilities has grown. To meet solvency requirements some life insurance companies were forced sellers of equity as equity values fell.” He states that proprietary UBS Warburg data on equity trading flows confirms that both insurance companies and mutual funds were large sellers.
