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The ethics of short selling

19 June 2019 Jessica Ground, Head of Sustainability at Global Asset Manager

Why are the JSE reserved about the FSCA’s proposal for stricter regulation of short selling?

The Financial Sector Conduct Authority’s (FSCA’s) short sale reporting and disclosure framework, proposed earlier this year, has been met with reservation by the JSE for a number of reasons. While the proposal is intended to tighten the regulations around short selling in South Africa, it is important to note that it is a few of the practitioners, rather than the practice, of short selling that can be unethical.

This is according to Jessica Ground, the Head of Sustainability at global asset manager, Schroders, who acknowledges that on the face of it, an investment strategy specifically designed to gain in value when companies fall in value may seem irresponsible. “While it undeniably has its more unsavoury side, short selling can also help manage risk more effectively and contribute to market efficiency. Its reputation is unfairly tarnished by the actions of a few cowboys.”

Ground says that, in practical terms, short selling involves borrowing a stock from an investor, and then immediately selling it in the hope that its price will fall and it can be bought back later at a cheaper price. “A profit is realised based on the price decline. At that stage it is returned to the original shareholder, who receives a fee for their troubles.

“It is only when investors take additional steps to influence companies’ financial health and value after they have bought or sold shares that ethical questions arise,” she explains.

As such, to assess the ethics of short selling, Ground believes it is important to consider the actions of different short sellers, rather than short selling as a principle. “In general, those actions reflect their motivations, which can be broadly split into four categories, namely: ‘stock picking on steroids’; the ‘activist shorter’; the ‘risk manager’; and the ‘emotionally detached trend follower’.”

The “stock picker on steroids”, Ground says, is very similar to traditional “long-only” investors, in that they both try to identify undervalued stocks, in the expectation that their value will converge on some estimate of fair value. “The difference between the two, however, is that the short seller will search for overvalued stocks or stocks which are facing structural headwinds that are not yet fully reflected in the price.”

The “activist shorter”, on the other hand, takes a more extreme approach than the “stock picker on steroids”, she adds. “Rather than assuming that the market will eventually price companies fairly, the activist shorter seeks to force the issue.

“However, the more extreme activist shorters are the ones that give the practice a bad name. Some have been guilty of spreading unfounded and malicious rumours in the press, a consequence of which is that they can earn a profit on their trade but push otherwise healthy companies into financial difficulties. Even if these companies manage to prove the accusations false, the short seller may be long gone by that stage, having booked a profit on their trade and left a trail of devastation in their wake,” says Ground.

Then there are the “risk managers”, who use shorting to control risk in their portfolios and express their views on particular stocks in as pure a way as possible. “Shorting allows a cleaner expression of a view on a particular stock or sector while also reducing volatility and risk of loss. The approach does not affect the health of individual companies, is typically low profile and doesn’t raise ethical concerns in our view.”

Lastly, Ground refers to the “emotionally-detached trend follower”, who seeks to profit from trends in markets; buying when markets are rising and shorting when they are falling. “These shorters employ strategies that are normally highly quantitative and systematic in nature, powered by powerful computer algorithms.

“Their emotionally detached nature means they cannot be accused of attempting to drive down prices. It is all about mathematics,” she highlights.

Considering this, Ground believes that short selling may have an unfairly bad reputation. “Rather than avoiding the practice, investors – especially those who are more ethically minded – may wish to ensure they understand its potential uses in a strategy and how its practitioners intend to behave.

“It can bring about significant benefits, both to investment performance and standards of corporate governance. Although some short sellers are unethical, short selling itself is not. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested,” she concludes.

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