The pros and cons of short selling

The pros and cons of short selling

Published on: 8 February 2021

Private investors got together recently via the social network Reddit to take action against short selling: speculation on the decline in the price of stocks or other securities. This has been going on for centuries, but is it still fit in with our modern times? Investment expert Patrick Bronger of APG takes stock.

 

A bridge in 17th century Amsterdam: a group of men (women were not allowed to trade in shares) has gathered around Isaac le Maire, a wealthy merchant and cofounder of the Vereenigde Oostindische Compagnie, or VOC (United East Indian Company), the first multinational in the world and the first company that issues shares. Le Maire has been thrown out of the VOC after a fight and is looking for vengeance and a way to feed his 22 (!) children.

 

Short selling avant la lettre

On that bridge, Le Maire sells VOC shares to the people present, where the price is determined through bargaining. (The stock exchange doesn’t exist yet. That is still a few years away.) This concerns so-called term contracts: Le Maire must deliver the shares at a later time against the price that has been agreed upon. If the price decreases in the meantime, he will make a profit. Short selling avant la lettre. That is allowed. But what does Le Maire? He talks down the price by spreading false rumors, for instance, that a VOC ship supposedly has sunk off the coast of Cape Good Hope. And that is not allowed. The price of the VOC shares indeed starts to go down.

 

Reddit rebellion

Fast forward to the 21rst century. At the end of January, private investors massively buy shares of GameStop, an American retail chain for video games, encouraged by internet forum Reddit. The price on the stock exchange increases very rapidly, causing the short-sellers – who just had bet on a decrease in the price of the poorly running company – to lose billions of dollars. That was exactly what the Reddit followers wanted to accomplish: they manipulated the share market to make a fist against the in their eyes reprehensible big business: hedge funds that supposedly enriched themselves improperly with their speculation on falling prices.  

Are the Reddit rebels right or does short selling also have advantages on the share market? How much does the pension participant notice? And: what is short selling exactly anyway? We asked Patrick Bronger, Expert Portfolio Manager Hedge Funds & Alternative Alpha with APG Asset Management. Here follows his explanation.

 

A lesson in short selling

Short sellers actually do exactly the same that Le Maire did, but then on a large scale. They speculate that the price of shares (or bonds, or raw materials, such as gold and silver) will fall. Why? “Because they think that those shares are valued too high on the stock exchange”, says Bronger. “If the company performs worse in reality, the price of the share will go down at a certain time. Short sellers take an advance on that.” Hedge funds also participate in short selling to cover the risk of investments with which they speculate that the price will increase (‘going long’). “If that jump in price does not happen, then at least they earn from the short shares.”

 

How exactly does that work?

Short-sellers borrow securities – for instance, shares – against compensation from brokers, pension funds, or insurers. “By the way, APG does not lend shares or other securities in principle”, Bronger emphasizes.  Then the short-sellers directly sell the borrowed shares at the rate that is then current at the stock exchange to another investor. He can lend the shares again to another short seller. This way the same shares can be used to take a short position. Compare it with e-tickets for a music concert: you can sell them as many times as you like. But those tickets allow entrance for only one person; with short selling, the shares can be used more times by different parties.   

At an agreed-upon time the short sellers buy back the shares again to return them to the party they borrowed them from, Bronger explains: “If the price has gone down in the meantime, they pay a lower price and they make a profit. But if the price has gone up in the meantime, they have to pay a higher price and they suffer a loss.”

 

Is there an ‘emergency stop’?

The profits, but also the losses can be enormous, like the loss of billions by the hedge funds with the Game Stop shares shows. When the losses become too large, the hedge funds sometimes use a kind of emergency stop, the kill switch, Bronger says: “They are going to buy many shares rapidly, in an effort to compensate for their loss in the short positions or to keep it as small as possible. However, often the time pressure is big, and more parties start buying at the same time, which drives up the price of shares enormously.” That is called a short squeeze. In the case of Game Stop the brokers – including the Dutch ones – shut down the trade-in shares to prevent high peaks.

 

Do the criticasters have a point?

The Reddit action is a reflection of the social inequality in the (American) society and exposes the dissatisfaction and anger about that. The Corona crisis plays a part in that too: people have a lot of savings and spend much time at home. Now that shopping for fun is no longer possible, some people start trading for fun. Apart from that, a part of the criticism of the Redditt-ers is rightfully so, says Bronger. According to him, it is also important to not tar all short sellers with the same brush and to separate the wheat from the chaff.

The chaff, that’s the modern-day Isaac le Maires. “In the 21st century, there are also short-sellers who spread false rumors and via social media that can be done a lot faster than on a bridge or in a coffee house”, Bronger laughs. However, now the involved companies can refute such rumors just as fast via Twitter, while back then it only appeared after 18 months or so that such a ship had sunk or that it had returned with a rich cargo.

On top of that, some short sellers take an aggressive stance toward the management of companies that they have their eye on. Another point of criticism is that short sellers make money on companies that already have a hard time and that push those companies into the abyss even faster. Speculation on a falling price then becomes a kind of self-fulfilling prophecy. On top of that, the market for short selling is opaque because of the loaning between themselves and the reselling of shares.

 

Are there also arguments in favor of short selling?

Yes, there certainly are, says Bronger. For that we have to look at the wheat: those are the short-sellers who thoroughly investigate companies. “That way they can signal differences between the valuation at the stock exchange and the true performance of a company at an early stage and even detect fraud or other abuses.”

Bronger takes the example of the American energy concern Enron, which collapsed in 2001 because of a bookkeeping scandal: “Nobody realized that the top people at Enron conducted business transactions with their own company, except for an analyst of their bank. Enron demanded that the bank would fire the critical analyst, after which he went to a short seller and announced the affair to the world.” The same goes for the Lehman Brothers: the bankruptcy of the business bank marked the beginning of the credit crisis in 2008. Three months earlier a hedge fund manager had already sounded the alarm about the weak financial position of the bank and irregularities in the bookkeeping. A recent example is the payment company Wirecard, for years the crown jewel of the German tech companies. The German overseer announced a ban on short-selling with Wirecard, until the so-called ‘rumors’ about irregularities with numbers turned out to be true. An enormous bookkeeping scandal was exposed, and the company went bankrupt.

So, short-sellers do have a function, poses Bronger: they can ensure that the price at the stock exchange forms a better reflection of the true value of securities and at the same time sound the alarm in a timely manner for problems with companies that are listed at the stock exchange. “And that is valuable information for investors, both professionals and private.”

 

Does APG participate in short selling?

APG invests a small part of the invested capital in hedge funds, which sometimes invest that via short selling. “If APG chooses for hedge funds, then we solely do that because of their knowledge and experience in specialized investments”, Bronger explains. In total it concerns about 22 billion Euros. That seems like a lot of money, but relative to the total capital of 573 billion Euros it is not even 4%. Bronger: “That fits in our policy to invest in different categories, to spread the risk as well as possible that way. Besides, we do not participate in short selling with the pension money that our teams invest themselves. So, in principle, APG does not lend shares to short-sellers.”   

To make sure, after the publicity around Reddit and Game Stop a stress test was performed, but it barely concerned APG in the investment portfolio. “We again considered the ethical aspects of short selling”, Bronger shares. “After all, APG is a long-term investor who wants to take a responsible position. But short selling can possibly help with that too.”

The valuable expertise and information of hedge funds can increase the return on the investment portfolio and decrease the risks because bad performances and problems with companies are shown early. On top of that, short-sellers sometimes denounce undesirable behavior: how companies are being managed, or how they treat their people and the environment. “As a large investor, APG can address those issues with those companies”, according to Bronger.

APG does want to handle short-selling responsibly. That means that the pension investors don’t build up enormous short positions but, as said before, spread investing. There is also a critical eye on partnerships: not with activist hedge funds with a short term focus and not with short sellers who spread misleading market information. So, not with the Le Maires of this world. “Our own investment teams keep a close eye on the social media for new Reddit-rallies, to be able to deal with that quickly”, says Bronger.  

 

1.5 million lost in 30 years

What actually happened with Isaac le Maire? The VOC persuaded the government to announce a partial ban on short selling, after which the price went up. Le Maire and his companions supposedly lost an amount with today’s value of about ten to twenty million dollars. Isaac died in 1624, approximately 65 years old. On his headstone is written ‘that in 30 years’ time, he lost more than 15 00000 guilders’, or about one and a half million.

 

The information about Isaac le Maire is based on an interview on the American radio station Planet Money with Lodewijk Petram, historicist, economist, and author of the book De bakermat van de beurs. (Thecradle of the stock market)