Are short-sellers the bad guys?

What is short-selling?

Traditional (long') investors look for companies that are undervalued by the market and buy their stock in the hope that their share prices will rise. By contrast, short-selling means finding a security (commonly a stock) that you believe is overvalued and placing a bet that the price will fall.

It is not a form of investment in the normally understood sense, but a form of financial speculation. The practice was back in the news this week because a well-known US financial firm specialising in shorting, Gotham City Research, published a damning report on a high-flying Spanish telecoms outfit called Let's Gowex.

The report argued that Let's Gowex's reported revenues were a sham and the firm's share price promptly slumped by 60% before being suspended. But this wasn't a case of a nasty short-seller profiting from scaremongering, it turned out Gotham was right.Days later the company went bust and its boss admitted thathe had been publishing dodgy numbers for years.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

How do you bet on a price fall?

In the strict sense, going short involves selling an asset that you don't currently own in the hope that you can buy it back later at a lower price and pocket the difference.

To do that you have to borrow it from someone who does own it paying a fee for the privilege and agreeing a deadline by when it has to be bought back and returned to the original owner.

Institutional investors, especially hedge funds, engage in short-selling for a variety of reasons. They may do it simply because they think a share is overvalued or, for example, as a tactical hedge against a long position. In other words, they want to reduce the risk on a particular investment they've made.

In practice, few retail investors have access to the kindof stockbroker's account that allows short-selling. However, they can achieve similar effects by using spread betting or contracts for difference,for instance.

Is this risky?

Very. Borrowing to invest is inherently risky, and this form of speculative investment is riskier than most. When you buy and hold £1,000 of shares, the upside is in theory unlimited: the price could surge and make you back many times your investment. But the maximum loss, if the firm promptly went bust, is limited to the original £1,000 you stumped up.

By contrast, when you short a stock by selling £1,000 of shares you don't own, the most you can gain (if the price slumped to zero) would be 100% of the value of your original investment (minus a chunk for the fees involved in borrowing the stock).

The potential loss, on the other hand, is in theory unlimited. If the shares surged tenfold, for example, you'd have to pay £10,000 to cover your short position.

Why is shorting so vilified?

Many people find the idea of betting on failure distasteful. And the suspicion that short-sellers may sometimes drive businesses into insolvency heightens that distaste. That's the main charge that has always been levelled at short-sellers: that they are cynical speculators who talk down companies and make a profit by encouraging the market to fall.

As a result, short-selling has often been subject to partial or total bans by regulators in many countries, typically during market downturns. The evidence on whether such bans work to restabilise markets is fiercely contested and is in any case impossible to assess with certainty, since there is no knowing what would have happened in a particular case if no ban had been introduced.

What is the case in favour?

The case in favour is that some companies deserve to fail and short-selling gives contrarian investors an incentive to hunt out the stinkers and the Let's Gowex-style frauds.

For example, it was shorters who first realised that something was wrong at Enron. Those who would ban short-selling misunderstand the nature and purpose of markets. A stock market is not a benevolent concern whose purpose is to allow firms to raise money regardless of whether they deserve it.

The market is a mechanism for allocating capital efficiently across the economy to firms who do deserve the money and financial markets servethe real economy best when they price in all information, not just the good stuff.

Shorting can also boost market liquidity. The more liquid a market, the easier it is for investors to buy shares at the prevailing market price.No doubt some short-sellers are shysters, but in the financial world, that hardly makes them unique.

How common is it?

Currently, not very. According to data compiled by Markit and published this week by the FT, the level of "short interest" in other words the percentage of overall stocks in the market that have been borrowed by short-sellers is at its lowest level since before the collapse of Lehman Brothers.

That implies that although several high-profile hedge-fund managers have warned about a toppy market, investors overall are not keen to bet against the current long rally and short investors will have been forced to close their short bets to avoid being squeezed.

Short interest in the benchmark US S&P 500 index is hovering around 2% of total shares in the index, compared with a high of 5.5% in 2007. In the Stoxx Europe 600 index, the level is just over 2%, while short interest in the UK FTSE All-Share index stands at less than 1%.