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How short selling really works


The Reddit / GameStop / AMC story dominated headlines and social media this week, sparking a renewed interest in both hedge funds and short selling. This bred an ‘us versus them’ mentality between well-organised ‘retail’ investors and the wealthy ‘hedge funds,’ and many people are referring to the practice of short-selling as ‘market manipulation’. In my view, this definition is somewhat of a stretch, given that someone selling-short can ultimately loose an unlimited amount of money on the trade. To suggest this is manipulation assumes that short-sellers control the market, which this week proved they clearly did not.

Stepping back, it’s worth summarising the difference between buying and selling – or going ‘long’ and ‘short’ respectively – in a company. Buying, or going long, is straightforward: you are taking an ownership stake in a company with the general aim that it will increase in value over time. Short-selling is the complete opposite, you are selling a company on the basis that you expect the value of that company to fall – you sell high, and buy-back lower. The reasons for selling are as varied as the reasons for buying: it may be a commodity company and you have a view on the outlook for commodity prices, or a fast-growing tech company that you don’t believe justifies its valuation. In some cases, short-sellers may take the view that a company is poorly managed, or is not telling the market everything, which is where the short-sellers’ most important role may be.

The process of short-selling is as interesting as the Reddit saga. In order for a hedge fund, or anyone for that matter, to sell a company short, they must first get hold of the shares to sell them. There is little point in short-selling shares you already own, as your returns will clearly be reduced. The most common source of shares available for short selling are long-term holders like index and pension funds. As these groups are effectively forced to hold very index-like exposures, their holdings rarely change throughout each year.

  • In return for ‘lending’ their shares to short-sellers, these groups receive a premium or payment for the period during which their shares are lent, which can be used to reduce the fees they charge to their investors. There are seemingly negative connotations with this practice, yet most financial market participants agree that it supports the efficient functioning of the sharemarket.

    Ultimately, the aim of short-selling is to borrow shares to sell at today’s price, in the expectation that the share price will fall and that you will be able to return those shares by buying them on the market at a lower price. This doesn’t sound like a fool-proof strategy to me, but rather one that requires a significant amount of experience and risk management to achieve successfully. Long-short strategies are becoming increasingly common, and available, in Australia, for a number of key reasons, but primarily because it increases the investment universe for fund managers.

    Consider for instance if you are running an active large-cap Australian share portfolio. Your investment universe is limited to the largest companies on the ASX, with just 15 holdings representing 50% of the entire market. Looking at the S&P/ASX 50, a long-only manager focusing on this index has just 50 investment options, whereas a long-short manager has double the investments available to them, for better or worse. There are many other reasons behind the popularity of these strategies, including the ability to reduce ‘market’ exposure and increase the contribution of your core long holdings, or where your research has uncovered a poorly managed or overvalued company. This research would go unused if you weren’t able to ‘short’ the stock.

    In an environment where participants are either calling the market a ‘bubble’ or suggesting it has a long way to run in 2021, short-selling may represent a rare opportunity for investors to diversify their exposure.

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