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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.