In defence of short-sellers

The collapse of construction and support-services group Carillion has left a lot of investors looking at losses. But others will be cracking open the champagne. Hedge funds reportedly made at least £300m by "short-selling" betting that the company's share price would fall.

Short-selling sounds complex, but it's fairly simple. The short-seller (often a hedge fund) borrows the stock that it wants to short from an institution that owns it (often a pension fund). The institution is "long" the stock, but it's willing to lend it to the hedge fund in exchange for an interest payment.

The hedge fund then sells the stock. If the price goes down during the period over which it has borrowed the stock, the short-seller can buy it back and pocket the profit before returning it to the pension fund. As of July 2017, more than 25% of Carillion stock was on loan to short-sellers it was the most-shorted stock on the London market.

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Profiting from disaster

The short-seller's profit is the difference between the original selling price and the price it bought the share back for. So if it borrowed then sold the share at £100, and the price fell to £75 before it bought it back, the fund would have made £25, less borrowing costs. However, if the price went up during this time, the short-seller would lose out. For example, if the price rose to £150 before the short-seller bought it back, then it would lose £50. And technically, losses are unlimited. A share price can only fall to zero but there's no limit to how high it can go. So it's very risky.

Some find the idea of profiting from a company's misfortunes distasteful.Yet the ability to profit by betting against a stock gives short-sellers a strong incentive to seek out and uncover bad business models and downright fraud, which in turn contributes to making the market more efficient and thus improves the process of allocating scarce resources to where they will be best put to work. After all, Carillion went bust because it was badly run, not because of short-sellers.

Shorts make for convenient scapegoats, but generally when a management team starts to accuse shorts of "attacking" its share price, you can be sure they're onto something witness the feverish denials from Britain's heavily shorted banks in the early days of the financial crisis. It's also worth noting that while hedge funds profited on this occasion, short-sellers also make plenty of expensive mistakes.

For example, online grocer Ocado has spent years on the "most-shorted" list, but has so far survived and cost many short-sellers their shirts in the process. Given the risks involved, we'd argue that the added scrutiny short-sellers can subject companies to makes their activities more than worthwhile.