The collapse of Carillion has reminded the public of the existence of short-sellers: stock-market participants who benefit from falling share prices. The construction giant was one of the most-shorted stocks on the market, and several hedge funds are reported to have made a killing when it went under in January. Short-sellers had been active in Carillion shares for several years, and around a quarter of the firm’s shares had been ‘sold short’. Reading of the profits made by these people, it is tempting to ask: is this something that an ordinary investor could, or should, be doing?
‘Shorting’ is simple in theory, but not so easy in practice. It involves selling a share you don’t own, in the hope that you might be able to turn a profit by buying it back at a later date for a lower price. But how can you sell something you don’t own? The answer is that short-sellers borrow shares from existing shareholders, who are willing to lend out shares in exchange for a fee.
Short-sellers are usually professional traders or investors who are running hedge funds or absolute return funds on behalf of clients, or maybe trading for their firm. Some wealthy folk might be using their own money to short-sell. Most small investors, however, do not short-sell — and for a good reason. Most stockbrokers do not facilitate it. Financial regulators do not seem to encourage it.
Why is this? Partly because the mechanics are quite complicated, but mostly because of the high risk involved. The most you can make on your money by short-selling is around 100 per cent, when a share price collapses to zero almost immediately. But the most you can lose? Well, there is no theoretical limit to how high a share price can go, so losses can become very large indeed. In theory, you can lose more than all of your money. Say, for example, you sell a share at £1 in the hope that you will be able to buy it back when the price falls to 50p. But then instead of falling, the share price rises to £2. You will still need to buy the shares back in order to return them to their rightful owner. But you will have to spend twice as much buying the shares as you sold them for. On top of this, borrowing shares involves paying fees. Short-selling is not something to undertake lightly.
Some online trading platforms — generally those that originated as spread-betting firms — do however make shorting possible for ordinary investors. Technically, rather than actually short-sell, you enter into a financial ‘contract for differences’, which can be a functional equivalent.
So should you become a short-seller — or a ‘merchant of doom’, as they are often called? My answer to this question is: please don’t try this at home. Good short-selling requires insightful information about a firm or a stock, patience in evaluating when to start shorting, speed and the ability to accept your mistakes (and take losses) when the evidence changes. It’s excruciating work — don’t do it.
That doesn’t mean, however, that short-sellers are not useful for ordinary investors. They are a bit like snow leopards: rare and hardly ever seen in the open. Nevertheless both play an important role within their eco-system. In the case of short–sellers, that role is to express a negative opinion about the price of an asset — which in many cases ordinary investors would do well not to ignore.
Short-sellers often receive a bad press, but they are incentivised to uncover corporate fraud, bad business practices, and accounting chicanery. They can thus help to keep markets ‘true’ to some extent. To use academic language, short-sellers help with price discovery. Famous cases of fraud, such as Enron, were first brought to the public’s attention by the agitations of short-sellers.
There’s also some evidence they can turn markets more liquid, making it easier for others to trade at the prices they want. Unsurprisingly, there have been several instances of market abuse by short-sellers, but most of the evidence suggests that they are useful members of the market ecology.
Short-sellers tend to be elusive for a variety of reasons, including fear of recriminations for bringing ‘bad news’ to the market. Sometimes, when share prices fall sharply, folk seek someone to blame, and short-sellers can make a useful scapegoat. After all, the short-seller wanted the share price to fall. Interestingly, I haven’t seen anyone blame the short-sellers for Carillion’s collapse. But there have been many examples in history, some quite recent, where politicians or business folk tried to persecute the short-sellers: bullying and threatening with words and even legal action.
Another reason for short-sellers’ reticence is the fear that others could exploit knowledge of their short positions by trying to engineer a share price rise, forcing the short-seller to buy back at a higher price to stem mounting losses.
There are, however, some short-sellers who publicise their views. They may publish detailed reports alleging aggressive accounting or corporate malfeasance; some even have Twitter feeds. The purpose of this activity is to ‘co-ordinate’ shorting activity and encourage others to short-sell at the same time: where a pack of short-sellers is fighting against the optimistic masses, they might just succeed in getting the share price down to a fair value. A lone short-seller stands little chance by comparison, until the weight of negative evidence becomes irrefutable. And that can be a long and painful wait.
Fortunately for ordinary investors, there is an easy way to find out what shares are being shorted and to what extent. The UK financial regulator publishes a list of all UK shares where one or more investor holds a large short position. It is updated daily and is free to access on their website: www.fca.org.uk.
But just because someone takes a large short position, this doesn’t mean the share price will fall. And it certainly doesn’t mean the firm is the next Carillion. Short-sellers act for a variety of reasons and may have other positions to offset against a specific short. Or they might simply be wrong in their evaluation of a good short. When shares rise unexpectedly, short-sellers may be unable to hold on to their shorts — and they might just lose their shirts.
James Clunie is manager of the Jupiter Absolute Return Fund and the author of Short Selling (Harriman House).