The good, the bad and the ugly of short selling

Jessica Ground, head of sustainability at Schroders

On the face of it, an investment strategy specifically designed to gain in value when companies fall in value may seem irresponsible. “While it undeniably has its more unsavoury side, short selling can also help manage risk more effectively and contribute to market efficiency. Its reputation is unfairly tarnished by the actions of a few cowboys," she says.

In practical terms, short selling involves borrowing a stock from an investor, and then immediately selling it in the hope that its price will fall and it can be bought back later at a cheaper price. “A profit is realised based on the price decline. At that stage it is returned to the original shareholder, who receives a fee for their troubles.

“It is only when investors take additional steps to influence companies’ financial health and value after they have bought or sold shares that ethical questions arise,” she explains.

Four categories of short sellers

As such, to assess the ethics of short selling, Ground believes it is important to consider the actions of different short sellers, rather than short selling as a principle. “In general, those actions reflect their motivations, which can be broadly split into four categories, namely: ‘

Stock picking on steroids

This type, Ground says, is very similar to traditional long-only investors, in that they both try to identify undervalued stocks, in the expectation that their value will converge on some estimate of fair value. “The difference between the two, however, is that the short seller will search for overvalued stocks or stocks which are facing structural headwinds that are not yet fully reflected in the price.”

the activist shorter

On the other hand, this category takes a more extreme approach than the stock picker on steroids. Rather than assuming that the market will eventually price companies fairly, the activist shorter seeks to force the issue.

“However, the more extreme activist shorters are the ones that give the practice a bad name. Some have been guilty of spreading unfounded and malicious rumours in the press, a consequence of which is that they can earn a profit on their trade but push otherwise healthy companies into financial difficulties. Even if these companies manage to prove the accusations false, the short seller may be long gone by that stage, having booked a profit on their trade and left a trail of devastation in their wake,” says Ground.

Risk manager

Then there are the risk managers, who use shorting to control risk in their portfolios and express their views on particular stock loss. The approach does not affect the health of individual companies, is typically low profile and doesn’t raise ethical concerns in our view.”

Emotionally-detached trend follower

Lastly, Ground refers to the emotionally-detached trend follower, who seeks to profit from trends in markets; buying when markets are rising and shorting when they are falling. “These shorters employ strategies that are normally highly quantitative and systematic in nature, powered by powerful computer algorithms.

“Their emotionally detached nature means they cannot be accused of attempting to drive down prices. It is all about mathematics,” she says.

Considering this, Ground believes that short selling may have an unfairly bad reputation. “Rather than avoiding the practice, investors – especially those who are more ethically minded – may wish to ensure they understand its potential uses in a strategy and how its practitioners intend to behave.

“It can bring about significant benefits, both to investment performance and standards of corporate governance. Although some short sellers are unethical, short selling itself is not. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested,” she concludes.