This article has been written by an expert contributor Caroline Gurney, the CEO of Future Generation Australia (ASX: FGX) and Future Generation Global (ASX: FGG).
Short selling
Whenever equity markets turn down, short selling ramps up – and so does the debate about whether it does more harm than good.
Unlike traditional “long” investors, short sellers seek to profit from falling share prices by borrowing and then quickly selling a stock, hoping to buy it back later at a lower price.
The pessimism that drives short selling is seldom welcomed by other market players – and especially not in times of market turbulence. While most investors have long viewed shorting as a legitimate investment strategy, short sellers still tend to get blamed when markets fall.
So is there any real value?
At the Future Generation companies, we are fortunate to have many of the country’s leading fund managers on our roster. Combined, they use a broad range of investment tools, including short selling, to try to achieve the best returns – both for our shareholders and for the many not-for-profits we support.
Not surprisingly, with many markets around the world enduring their worst start to a calendar year for decades, the subject of short selling came up several times during our national investor roadshow. Investors wanted to know whether short selling undermines markets; whether it erodes the financial stability of companies by artificially lowering stock prices; and whether it is “ethical” for short sellers (typically sophisticated investors) to profit while others lose money.
What do the experts think?
I put these questions to some of Future Generation’s fund managers
Jun Bei Liu
“I think short selling, unfairly, gets a bad rap,” says Jun Bei Liu, Lead Portfolio Manager for Tribeca’s Alpha Plus Fund. “All it does is allow us to deliver gains to our investors not just from shares going up, but also from shares going down. These shares were going to go down regardless of whether we were short the stock or not.”
Liu’s Alpha Plus Fund’s performance has been boosted over the past nine months by short positions on Australian consumer discretionary businesses. She says that about 50 per cent of her “active” returns – in other words, her outperformance of the market – come from short bets.
Phil King
Similarly, Phil King’s Regal Funds Management, a long-short investor, has enjoyed some of its best returns on the short book in the last six to nine months. “Shorting allows us to generate returns from our stock picking, not just from the market going up,” he says.
Far from undermining financial markets, King argues that short selling can help drive market liquidity, price stocks more efficiently and mitigate market bubbles.
“Short selling provides a really good offsetting impact to get share prices to fair value,” he says. “The ability to short also provides us with flexibility. Not only can we benefit from the falling market, but we can then use our short book to provide funding to take advantage of price weakness on quality companies.”
Gabriel Radzyminski
Gabriel Radzyminski, whose own fund Sandon Capital engages only minimally in short selling, agrees that the practice “absolutely adds value”. “The vast majority of short selling occurs day in, day out in large liquid stocks as part of healthy market operations,” he says. “Overall, it’s beneficial for the markets because of the liquidity it provides. The more liquid the market is, the better it operates.”
Radzymynski, who sits on the Future Generation Australia Investment Committee, points out that short selling is used differently by different fund managers. Many use it to hedge their risk, through pairs trading or relative value arbitrage. Such “market neutral” or “long-short” funds can produce stellar results for their investors, which include mum-and-dad shareholders and SMSFs.
But, of course, the short sellers who tend to garner all the media attention – and retail investor ire – are the activist short sellers. These sellers typically take a short position, then publicly disseminate information criticising the company’s finances, management or future prospects, with a view to driving down the share price.
Mathew Kidman
Matthew Kidman, principal of Centennial Asset Management, says these short sellers can play an important role in exposing corporate frauds and flawed business models. “It’s an efficient way of exposing companies when things haven’t gone right,” he says. “That’s a good thing.”
Tom Richardson
In cases where they overstep the mark by spreading misinformation, Australia’s corporate laws relating to market manipulation or misleading and deceptive conduct can be brought to bear. “Ultimately, if someone does the wrong thing and manipulates the market, then the same rules that apply to the upside, apply to the short side,” says Tom Richardson, of Paradice Investment Management. “There’s nothing sinister about short selling. It’s just another seller in the market, having a different view on price and value.”
Pointing to the example of Peloton, once the darling of pandemic workouts, Richardson says that short sellers are often blamed unfairly for shareprice collapses. He says short interest in Peloton peaked at nearly 9 per cent in January 2020, when the share price was just US$32 – and before it climbed to more than US$160. Then, as the shareprice tanked from nearly US$100 to US$40 in the third quarter of 2021, short interest halved from 5 per cent to 2 per cent. “In other words, the shorts were buying,” says Richardson. “All that shows is that the shorts were horribly wrong early on, and ultimately had little impact on the large share price fall.”
Geoff Wilson (AO)
Geoff Wilson, Chairman and Chief Investment Officer of Wilson Asset Management and founder of the Future Generation companies, agrees that short sellers often cop the blame unfairly. He points to the Global Financial Crisis of 2008, where fingers were pointed at short sellers for the collapse of companies like Centro, Allco and Babcock & Brown.
“What the short sellers exposed over that period was actually that those companies had flawed business models, which ended up being 100 per cent correct,” he says. Wilson’s only caveat is when short selling has a negative impact on a company’s underlying business. “A bank’s underlying business relies on confidence,” he says. “If that gets called into question, it could cause a run on the banks.”
For Wilson, this caveat does not extend to situations where short selling impacts a company’s ability to raise capital. “The question is: should companies assume that they will always be able to raise capital?” he says. “Companies must understand that it is a privilege to be able to raise capital. You can only do it when shareholders believe it is for something positive – it’s not a tool to survive.”
Effectiveness of previous bans
Throughout history, short selling has been banned sporadically on international stock exchanges as markets crashed, in an effort to improve market confidence and reduce volatility. Most recently, at least seven countries banned the practice in response to the sharp stock market falls in March 2020.
However, a number of studies after the 2008 financial crisis called into question the effectiveness of bans. In 2011, the Federal Reserve Bank of New York concluded that “banning short selling does not appear to prevent stock prices from falling” but instead “lowered market liquidity and increased trading costs.” The European Systematic Risk Board reached similar conclusions.
Understand the risks
With local and global sharemarkets under serious pressure, many fund managers believe that short selling could become more widespread in Australia as investors adopt the practice for the first time. Shorting, they argue, will provide investors with a means to diversify their portfolios during a period when equity markets are no longer a one-way trade.
“I think Australia will become a bit more like the US, where you have more people short selling stocks and in bigger quantities,” says Centennial Asset Management’s Kidman. “But there’s a limitation to it. The majority of money invested in Australia comes from retail and institutional investors, and they are both naturally long-only. Shorting is a dangerous game. You can lose money really quickly!”
Gabriel Radzyminski agrees that there is a time and place for short selling.
“It’s terrible when you get it wrong,” he says. “If you are long, your losses are limited to when the share price hits zero. In short selling, your losses are unlimited because the share price can just keep climbing. Plus short selling introduces leverage into the equation.”
Or, as Phil King, quips: “Long short investing – twice the way to make money, but also twice the way to lose money!”
For more on Future Generation and their social investment achievements, check out the links below.
Caroline Gurney, the CEO of Future Generation Australia (ASX: FGX) and Future Generation Global (ASX: FGG), Australia’s first listed investment companies to provide both investment and social returns.
The companies provide shareholders with exposure to leading Australian and global fund managers, who aim to deliver a stream of fully franked dividends and capital growth, without charging any management or performance fees. Their generosity allows the Future Generation companies to invest 1% of net tangible assets each year in their not-for-profit partners. Shareholders decide which not-for-profits will receive the donation, whether it’s supporting children and youth at risk (FGX) or investing in the prevention of ill mental health (FGG). The Future Generation companies have donated $65.2 million since inception.
Prior to making an investment decision, retail investors should seek advice from their financial adviser. This document is intended as general information only.