Short-sellers have endured a rotten 2021 and to cap it all, they now face an investigation by the US Department of Justice. Despite an important role in financial markets, the tactics of some funds will once again be under scrutiny.
The criminal investigation will look at research reports issued by short-sellers and whether they have used their relationships to depress stock prices, according to reports of the probe. The DoJ did not immediately respond to a request for comment.
Small investors on Reddit, where much of the hostility towards hedge funds during the GameStop frenzy earlier this year was voiced, reacted to the news with a mixture of glee and scepticism that any action would be taken as a result of the probe. “Good! It’s long bout time for some heads to roll!!!” wrote one Redditor.
Short-selling, hedge funds’ trademark tool of betting that a share price will fall, has long been a controversial tactic. It is sometimes viewed by critics as a way of feeding on the misery of companies and workers and of driving down the share price of good companies, despite academic evidence to the contrary.
But the timing of the DoJ probe is ironic given that, rather than making huge gains from their tactics, short-sellers have in many cases been going through a miserable time in recent years.
Reddit-led buying of meme stocks such as GameStop earlier this year caught some funds off guard, notably Melvin Capital, which is still down about 40 per cent this year.
And in an environment of ultra-cheap money, stocks with little in the way of current revenues can soar to huge valuations because of the greater weight afforded to expected future cash flows. That has made them dangerous targets for hedge funds, some of whom have taken a while to realise their mistake.
“I was so often finding myself short very expensive shares which was endlessly costly,” wrote Crispin Odey, founder of Odey Asset Management, in a letter to investors seen by the Financial Times. “It dawned on me only slowly that all equities are cheap. They are cheap against bond yields.”
Money managers betting against Tesla, including Michael Burry of The Big Short fame, have now largely thrown in the towel, realising that, whether or not their thesis is right in the long term, betting against the stock is just too costly in the short term. “In the present environment of Reddit-led investing, it is very dangerous to short anything that has momentum,” noted Peter Sleep, senior investment manager at Seven Investment Management.
And short-sellers have also beaten a retreat at Australian biotech Clinuvel after the company took the unusual step of taking them on head-on. The company’s methods included vocal attacks on the short-sellers and commissioning private investigators to examine their alleged links to retail shareholders posting on online forums.
But while the going has been tough, short-sellers’ impact on financial markets and real world investment can still be large.
Academics at the Wharton School, Bayes Business School and Warrington College of Business in Florida recently found that reports issued by short-sellers, many of which expose accounting fraud or other corporate misconduct, led to an average 4 per cent fall in the target company’s share price on the day a short report was published. That drop increased to 24 per cent over a period of up to six months, the research found.
Short-sellers tend to be ahead of analysts at Wall Street banks, who react to the publication of the reports by cutting their price targets. Targeted companies also ended up reducing their corporate investment by $118m on average, and their stock issuances by $179m.
Hedge funds’ bets against scandal-hit companies such as Wirecard, where funds made €1bn in a week, and Steinhoff highlight the important role they can play in identifying problem companies.
“The idea that short-sellers don’t have a role to play because they drive good companies into bankruptcy is not a view that I subscribe to,” said David Miller, executive director at Quilter Cheviot Investment Management. “A well-functioning market needs liquidity which means that traders prepared to take different views and positions are welcome.”
Whatever the result of the DoJ investigation, short-selling can, provided it is used legally, prove beneficial for markets. With tighter monetary policy from central banks set to put the squeeze on fraudulent companies and unsustainable business models, short-sellers could soon start to feel more of the benefits for themselves.
