Roundtable: Is Short-Selling Evil?

As part of our special series on short-selling, we asked several Fools to weigh in with their views on whether being able to sell short is a good or bad thing for financial markets in general. Here's what they had to say about short-selling.

John Del Vecchio, Fool contributor: The Holy Grail of investment management is an equity-like return with bond-like volatility. If you have any aspirations of managing other people's money and can achieve this return / volatility result, you will attract more assets than you can handle.

The best way to achieve this Holy Grail is to "hedge" your portfolio. Most pundits will argue that diversification helps smooth performance. However, 2008 illustrated that the financial markets are more interconnected than at any time in history, and when liquidity disappears, nearly everything can head down the tank together. With the exception of gold, bonds, and the U.S. dollar, most asset markets showed nearly perfect correlations with each other as they fell. Diversified but un-hedged meant disaster of epic proportions -- and it will happen again at some point.

Selectively shorting stocks (and possibly ETFs) allows one to generate excess return over an index on both sides of their portfolio, both by making "long" bullish bets as well as "short" bearish bets. Good stock picking in a hedged portfolio results in lower stock market exposure with the opportunity for outsized returns.

Chuck Saletta, Fool contributor: Without the ability to short sell, there'd be significantly less value for accounting sleuths to publish accurate but negative information about a company, since they couldn't easily directly profit from it. It was a short seller, after all, that uncovered the fraud perpetrated by Enron and its supposedly independent auditor Arthur Andersen. Without that truly independent vigilance brought on by the ability to profit from exposing the misdeeds, who knows how long the fraud could have continued?

In addition, from a purely mechanical standpoint, the ability to short is a critical part of keeping stocks and their options anywhere close to appropriately priced. The art and science of arbitrage -- of trading on market inefficiencies to gain a risk-free profit -- would not be possible without shorting. And by both helping keep pricing in line and providing liquidity through their trades, arbitrageurs go a long way toward helping keep the market functioning smoothly. Take away the ability to short, and you weaken the overall health of the market.

Dan Caplinger, Fool contributor: I understand that short-selling can be useful for risk management. For instance, shareholders of XTO Energy (NYSE: XTO  ) , which agreed to merge with ExxonMobil (NYSE: XOM  ) last year, can sell short shares of Exxon. Then, when the merger closes, they can use the Exxon shares they'll receive to close their short position. At current prices, that would yield a bigger profit than merely selling their XTO shares directly.

The troubling thing about shorting is that it creates an incentive for investors to see companies -- or as we're seeing in Europe, entire governments -- to fail. Some will argue that these failures are inevitable, but when derivatives like credit default swaps hasten the process, they can prevent solutions that might have worked given more time. In those cases, the gains short-selling investors reap can be far less than the cost to other stakeholders, including not just shareholders but also employees and the broader communities that depend on those businesses.

Banning short-selling isn't the answer. But placing some limits on the practice won't keep the markets from functioning.

John Reeves, manager, Motley Fool: Shorting is essential for markets, and I believe that short-sellers have gotten a bad rap in recent years.

Ironically, it's the big investment banks that are most responsible for soiling the reputation of short-selling. First, we had Lehman CEO Dick Fuld blaming his firm's bankruptcy on David Einhorn, a hedge-fund manager who had shorted Lehman. More recently, Goldman Sachs (NYSE: GS  ) has been widely criticized for shorting the housing market, a strategy that wasn't always aligned with its clients.

To the average investor, short-sellers now appear to be amoral operators who have both the ability and the desire to bring profitable companies to their knees.

The truth is much different. According to a recent study, short-sellers have succeeded as a result of, "thorough astute research and analysis, not market manipulation." And the most likely source of their edge is that they "have a superior ability to analyze publicly available information."

So it's time to rehabilitate short-selling. Remember, say what you will about David Einhorn -- on the subject of Lehman, he was right!

Tim Beyers, Fool contributor: Imagine a market without shorting, and you'll know why short-selling is such a crucial practice. First, there would be no effective mechanism for throwing out the market's trash. I'm talking about stocks like Westwood One (Nasdaq: WWON  ) , which is still losing money despite an advertising recovery and trades for more than 20 times its book value. What if we were forced to either buy or ignore these stocks? The resulting artificial stimulus -- in this case, a lack of sellers -- would cause the shares to rise for no good reason.

Second, there wouldn't be enough bears. Short-sellers dig into company financials like few others and do the rest of us a service in the process. They diagnose scams and reveal overpriced merchandise for what it is. Banning them increases the likelihood of financial shenanigans succeeding. I can't be the only Fool who thinks that's a frightening prospect.

Do you think short-selling is a necessary part of functioning markets or an evil that needs to be stamped out now? Tell us what you believe by leaving a comment below.

Fool contributor Dan Caplinger compiled this roundtable article. He doesn't own shares of the companies mentioned. The Fool owns shares of XTO Energy. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy won't leave you short.


Read/Post Comments (8) | Recommend This Article (18)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 04, 2010, at 3:09 PM, obamabumper wrote:

    Short Selling is evil, typically done by evil hedge funds with no regard to regular folk. These funds should be banned and Obama should take all their money and split it among the individuals impacted by the oil spill.

  • Report this Comment On June 04, 2010, at 4:03 PM, DJDynamicNC wrote:

    Like all such things, short selling deserves careful watching and regulation.

    But after reading this, I admit I'm more open to the positive nature of short selling. Good article, Fools.

    I'm now long on shorting!

  • Report this Comment On June 04, 2010, at 4:52 PM, brickcityman wrote:

    @ obamabumper... jeez could you be any more of a right-wing caricature?

    The fear of short selling has always amazed me... because to me its really born out of a failed assumption that the morally correct path for a market is up.

    Check all the news websites today... they will likely have some mention of the market dropping by X points (probably hundreds since the DOW receives the most attention). Yet people do not seem nearly as concerned when the market sky-rockets up by an equivalent amount.

    A volatile market is the thing to fear because its an indicator of disconnect between the market and the real economy, the sooner we collectively realize this the better.

  • Report this Comment On June 04, 2010, at 5:07 PM, MasterSnax wrote:

    Short selling is a crucial feature for a properly functioning market. There is nothing inherently evil about it. One of the basic tenets of modern economic theory is that different agents have different preferences and beliefs about what will happen in the future, leading to different valuations for the same product, and allowing for transactions to occur that benefit both parties (in their own opinions, of course).

    Short selling simply opens an avenue to express the view that a stock -- or other instrument -- is overvalued. One of the problems in the housing bubble was precisely the fact that shorting the housing market was relatively hard to do.

  • Report this Comment On June 05, 2010, at 9:23 AM, EvilPhD wrote:

    Short selling creates artificial volatility completely regardless to a company's performance. A savvy group of managers with significant volume can play puppet master with stocks in companies that are doing very well.

    The more people are shorting the more the volatility increases because as has been witnessed by these disgusting and irrational flash crashes - most of it is due to massive amounts of short selling. This tanks companies, entire markets, even now countries.

    The euro is hurting - OMG chicken little hit the short panic button, drop the value of the stock - that triggers massive amounts of stop losses which amplifies the drops then drops entire sectors that are actually reporting great balances and profits.

    These gains that are talked about are pathetic compared to the crazy stupid flash drops due to these shorting. There are no checks and balances. The money comes straight out of solid company's pockets. Punishment for performance.

    A healthy market would have a good mix of gains and losses. Where is that mix today? This current and rapidly option dominated market is not being fair or true to companies that are doing well or their investors.

    In the end these short sellers are going to be the cause of the next crash. The market needs to get back to basics where a company's stock is a reflection of it's worth.

  • Report this Comment On June 05, 2010, at 10:30 AM, hrdnitlr wrote:

    This is all just silly. At least it seems like it to me.

    This is a topic complex enough that it's easy to say things so general that no one could disagree with, and that's what the panelists are doing. They're hiding out in generalities.

    The fact is that it's the volume of short selling that's the issue. A modest amount, particularly as a legitimate hedge, has always been with us, and hasn't in and of itself been harmful. But the practice of virtually unlimited hedging (especially naked hedging), against any type of market instrument regardless of its complexity (CDOs), with a large number of brokers who can facilitate it (remember, the Paulson fund had to shop several brokerages before it found one that would put the transaction together for it) is, clearly, a problem.

    But to get away from the mechanics of it and get to the "moral" (not my favorite word) point of it: it makes the marketplace dysfunctional if the negative bets on any type of business or market instrument dramatically outweigh the positive. Then, you've created a too-large community that has an incentive to see that business or instrument fail. That sword cuts both ways - - it motivates the bear to put the target under deep scrutiny, which can be good. BUT IT ALSO TOO EASILY ENCOURAGES TOO MANY PARTIES TO LOOK THE OTHER WAY (and suspend common sense) WHEN A BUBBLE IS FORMING. If you can structure a straightforward way to profit (or protect your profits) when too much capital may have wrong-headedly found its way into an asset class that doesn't deserve it (like real estate in 2007-8), you have every incentive to just let it ride, to let the bubble grow as big as it can.

    LARGE-SCALE SHORTING MAKES IT TOO EASY FOR REASONABLE PEOPLE (and institutions) TO BE INDIFFERENT TO UNWARRANTED ASSET INFLATION.

    Now, you will also note that all the panelists above subtly acknowledged that some sort of limits or better transparency on short selling were desirable, even necessary. None of them is arguing that infinite short selling is desirable.

    But where we have a problem is in the professionalization of short selling. The aggregate economy, in a perfect world, would benefit when all businesses become increasingly well run, and more profitable. But as more and more institutional investors chase that holy grail of outsized rewards and constrained (hedged) risk, it's like we have created a generation of investors who went to a bizarro business school where they were taught how to identify businesses that would fail, build businesses that would fail, and promote businesses that would fail. So the problem is that too many people are too eager to make or preserve their capital by making profitable bearish bets.

    This in effect has created an insatiable need (and demand of Wall Street) to build ever bigger securities markets with ever-bigger "off ramps" of potential negative bets on them.

    The last defense of those who would lionize short selling as a healthy tonic for the market is, in effect, that there's no way to prevent the egregious effects of short selling without ending the practice in ways that would be patently unfair to some group of law-abiding, profitable investors. They are correct. That is indeed a legitimate problem, morally - - the punishment of some of the innocent. But the 2008-2009 experience, if it's taught us nothing else, shows that if you let the professional investor community's imagination run wild, you wind up with people (like Fabrice Tourre) selling products they admittedly do not understand. At the most powerful investment bank in the world. With the smartest people.

    No one should be able to facilitate bets against other parties in ways that they themselves do not understand. That is essentially the definition of lawlessness for participants in the financial markets. And it crosses the line of what constitutes fair and square investing.

  • Report this Comment On June 24, 2010, at 11:12 PM, tralvex wrote:

    Stocks are mostly (if not all) either overpriced or underpriced despite what EMH theorists claimed.

    Given these scenarios,

    (1) Investor X owns 100,000 of an 'overpriced' stock and sells it for $100,

    (2) Investor Y brought 100,000 of the same stock at $100,

    (3) Investor Z sell short 100,000 of the same stock at $100.

    Q1. Is Investor X more angelic than Investor Y?

    Q2.Is Investor X more angelic than Investor Z?

    Q3. Is Investor Y more angelic than Investor Z?

    Q4. Is Investor X more investment-savvy than Investor Y?

    Q5. Is Investor X more investment-savvy than Investor Z?

    Q6. Is Investor Y more investment-savvy than Investor Z?

    We should review the short sellers in a more holistic perspective rather than narrow.

  • Report this Comment On June 25, 2010, at 1:21 AM, tralvex wrote:

    On the flip side, other scenarios for consideration:

    (1) Investor X owns 1,000,000 of an 'undervalued' stock and sells it for $1,

    (2) Investor Y brought 1,000,000 of the same stock at $1,

    (3) Investor Z sell short 1,000,000 of the same stock at $1.

    Q1. Is Investor X more angelic than Investor Y?

    Q2.Is Investor X more angelic than Investor Z?

    Q3. Is Investor Y more angelic than Investor Z?

    Q4. Is Investor X more investment-savvy than Investor Y?

    Q5. Is Investor X more investment-savvy than Investor Z?

    Q6. Is Investor Y more investment-savvy than Investor Z?

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