The safest way to avoid another rumour-fuelled run on HBOS, argued a letter to The Times last week is to ban short-selling. This is the practice of selling shares that one does not actually own in the hope of buying them back at a lower price.
This is only possible if one can borrow shares, to be delivered after the initial trade to the buyer. So another Times' correspondent argued that stock lenders should also be liable for punishment in the event that the short seller is found to be profiting from peddling false rumours.
The latter is not a bad idea, although given the FSA's hopeless record of prosecution in the whole field of fraudulent dealing I would not have much hope that it would make any difference. However with the financial system now collapsing around our ears the inquest is under way; and short selling will come under the microscope. So let me try to line up the arguments for and against, starting with the former.
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A new way of making profits
Short selling, we are told, is good because it provides investors with a whole new way of making profits. In the old days investors could only make capital profits if asset prices were appreciating. Now they can also make money if asset prices are going down. Through a judicious mixture of long' and short' positions investors can both enhance and smooth their overall returns.
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The second argument is that short sellers provide a useful counter to excessive bullishness. We take it that we want the price of financial assets to be, so far as possible, correct. Volatility is a bad thing because the mispricing of financial assets causes people to make bad investment and business decisions, or to be scared off altogether. And at the extreme short sellers can sniff out a can of worms such as Polly Peck of Maxwell and bring an end to such fraud.
These are the arguments for short selling, and I do not think that either of them are good ones. It is true that money can be made from short-selling. It is also true that a combination of long' and short' portfolios can reduce the volatility of an investor's total return.
But short selling is only one side of a zero sum game. For every short seller who is making money, there is a holder of those securities who is losing it. In aggregate short selling is of no benefit whatsoever to all those who trust their savings with fund managers. It is simply a new way that the ever inventive City has found to cream profits off the national pot of savings.
Why the short term view is not a good thing
So does short selling contribute to the accurate pricing of financial assets? The evidence is that it does not. Given that short sellers can not only take a contrary view to the bulls but can also act upon it and pull share prices back from an overly optimistic level, they should have had the effect of reducing the volatility of the market. It certainly does not feel like that, and a paper last year from the London School of Economics found not only no lessening of volatility but also that the stock market's blue-chip share indices, representing shares in established and thoroughly researched companies, were more volatile than the indices of risky and under-researched small companies. This should not be the case, and is at least partly because short sellers and other traders with a sort time horizon operate in large liquid shares.
The fact is, of course, that most short sellers can just as easily become bulls and vice versa. These short-term funds will ride any prevailing trend, adding fuel to a bull run before turning on a sixpence and further undermining shares that have started to slide. And because short sellers are usually hedge funds that can gear up massively and punch well above their weight traditional managers of pension and other long term funds, who are all anxious about the next quarterly performance review, will not attempt to stand in their way. So the short-term view prevails and I have never met anybody in business who thinks that is a good or helpful thing.
You also have to ask whether short selling is a necessary way of introducing a bearish view into market prices. Long before the term hedge fund was coined or short selling became commonplace, share prices always teetered between the bullish view and the bearish view. In the absence of short selling share prices were determined by the weight of these arguments, and by whether those who owned certain shares felt comfortable doing so, whether they were inclined to sell or to add, and whether others were inclined to buy into the story. It is true that broker research is hopelessly compromised by corporate ties these days, so that any genuine independent negative view is rarely expressed on paper. But that does not mean that bearish views do not, or have not always, existed or have not found their expression in asset prices.
So the arguments for short selling just do not stack up. The City's role is to support the growth of the economy through the allocation of investment capital into profitable ventures. This calls for a positive, constructive mindset that looks beyond the next few weeks and months. The mindset of short sellers is quite the opposite.
This article is taken from Tom Bulford's free daily email Penny Sleuth'.
