Short Selling - The Myth and the Madness

Short selling on the world's equity market is under fire once more, and hedge funds have found themselves in the front line. The charges are simple: probably simplistic. Markets have taken some sudden downward lurches; shares fall when there are more buyers than sellers, so short selling must be exaggerating the size of the falls. Hedge funds are short sellers. Round up the usual suspects. The sniping has not been restricted to hedge funds, the proprietary trading desks of the big investment banks have also come under fire. Many of the attacks on equity long/short hedge funds have come from politicians whose constituents have seen their investments eroded by the falls in stock markets, and who want someone to blame.

Hans Eichel, Germany's finance minister, has branded hedge funds a threat to financial stability and earlier this year called for a temporary ban on short selling. Such political tirades are not new. In the Asian crisis of 1997, when Malaysia's currency was being savaged, the country's Prime Minister, Mahathir Mohamad, saw the hand of George Soros, who profited heavily when sterling was devalued in 1992. Mahathir declared that hedge fund managers were the "highwaymen of the global economy." Soros was once again demonised in Hong Kong in 1998 when the local dollar peg against the US dollar appeared to be crumbling, forcing the government into massive and controversial stock market intervention. Being slapped around by politicians is nothing new for hedge funds, but what probably hurts more is that some of the attacks now being mounted come from within the financial community. Blaming hedge funds for poor market conditions is being seen by some as a smoke-screen laid down by conventional fund managers to hide their own shortcomings. Despite the accusations, the assaults on hedge funds appear to have been backed with little hard evidence.

A keen UK follower of the development of the funds, Professor Harry Kat, Associate Professor of Finance at the University of Reading, says, "Since the effect of hedge funds on stock market volatility is quite a new subject I do not know anybody who has taken a serious look at it." He concludes that the hostility is just the latest example of a demonisation by the ignorant of one sector of the market place. "People look for a scapegoat because they don't understand what is going on any more," he says. After examining the charges against hedge funds, Swiss-based investment bankers UBS Warburg declared them not guilty in a July research report titled Peaches, lemons and sour grapes. "As global equity falls accelerated in June and early July the voices against hedge funds grew louder and more numerous. They did not, in our view grow any more informed, enlightened or intelligent, " countered analysts Alexander Iniechen and Jen Johansen. UBS points out that, rather than cleaning up by short selling, most hedge funds suffered a horrible month in June. July was little better. Although the slump in major markets would appear to have provided perfect conditions for hedge funds to make big money out of short plays, they were generally in the red.

The ABN AMRO EurekaHedge Asian index lost 1.1% over the month, and the Japan index fell 0.3%. Long funds, however, did much worse. According to the UBS report, the simple reason for the falls in the market is selling by the majority of market participants, which massively outweighed any hedge fund actions. By UBS' calculations, hedge funds accounted for only US$600 billion of the total US$20 trillion to US$30 trillion under global management, a figure that would suggest that their influence on the market is being exaggerated. For Asia, EurekaHedge's figures suggest that of the $17 billion in Asian-centred funds, only 30-40%, or $7 billion, are short sales. That's hardly enough to have a significant impact on the cash markets. In the US however, hedge funds are energetic players of derivative instruments, which can move the main markets. According to reports from the US, hedge funds account for as much as 50% of the S&P futures transactions on the Chicago Board of Options Exchange, more than double the figure of a year ago. Defenders of hedge funds, and their ability to short, point out that not all those contracts were one way. Hedge funds and other users of short selling strategies, reduce volatility. Recent one-day swings on Wall Street may have been spectacular, but they never reached anything like the daily shifts seen in 1987; and the growth of short selling has been a key a factor in ironing out the swings, say hedge fund supporters.

Barry Eichengreen, a former policy advisor to the International Monetary Fund, and Professor of Economics and Political Science at the University of California warns that restrictions could do more harm than good. "Hedge funds could help break the free fall that can afflict oversold markets, including currencies", he concluded. "When the shorts decide to cover, their buying can provide a floor to the market, and even out intra-day swings." So far the recent attacks on short selling by hedge funds and other players in Asia have been muted. The exception was Japan. In February, Japan's powerful Financial Supervisory Agency introduced the uptick rule in an attempt to cut the alleged impact of short selling on the Nikkei 225 index. Players would be able to short a stock only at a price above that currently prevailing in the market. This move was regarded as a market support operation, but was aimed both at hedge funds and the proprietary trading desks of bulge bracket investment houses, and has been followed up by harsh disciplinary action against some of the biggest names in investment banking who broke the rules. Rather than lashing out at hedge funds for unsettling markets, some Asian jurisdictions are leading the way in widening the market for hedge funds. Both Hong Kong and Singapore, which have strict rules on short selling, are in the process of registering hedge funds for retail sale. Some market regulators are resisting calls for clamps on short selling by hedge funds, or any other institutions.

Sir Howard Davies, chairman of the UK's Financial Services Authority has dismissed suggestions of a ban. Short selling was "a necessary and desirable underpinning to the liquidity of the London market". The benefits of short selling are too strong for any serious curtailment, but arguments for greater transparency of short positions are growing stronger. While some hedge fund managers express concern that this would cramp their style, a greater ability for the authorities to see who is really playing fast and loose with their markets could take the heat off.