Ethics of Shorting – Rooted in Capitalism and Democracy

    Stockholm (HedgeNordic) – For those of us who work with hedge funds on a day-to-day basis, going short is as natural a concept as going long. If you can go upstairs, you should also be able to go downstairs. But let us step back for a few minutes, and put ourselves in the shoes of traditional investors or people outside of the investment community. Shorting has sometimes earned bad press and been singled out as an unethical investment practice. We decided to have a closer look and ask four long/short managers how they view this hairy question and we found that each of them had quite strong opinions indeed.

    What’s in a name?

    “Public opinion of shorting is a reflection of the coverage short selling receives, which is almost universally negative,” starts Alex Tselentis at London-based sustainability-focused asset manager Finex. “Derided at the height of the last financial crisis short selling has become synonymous with negativity, crisis, and above all, deriving profits from others’ misfortunes. Such a one-sided misrepresentation leaves shorting misunderstood. Consequently, shorting has become a difficult conversation at times, and many asset managers (due to fear of upsetting potential investors) fail to defend the practice, preferring instead to leave misconceptions unchallenged.”

    At Adrigo, a Stockholm-based long/short equity manager, CEO Stefan Gavelin cautiously states: “We have actually not encountered investors who believe shorting is unethical. However, it is understandable that some investors may have the view that it is not ethical as you make money on a company performing badly.”

    At London-based Jupiter Asset Management, long/short fund manager James Clunie had to play devil’s advocate: “I’ve met folk who asked me about the ethics of short-selling, mostly as a philosophical matter or because they’ve heard others raise the issue. I’ve even taken part in a debate on this topic at the University of Edinburgh – I was given the task of trying to demonstrate that it could be unethical!” As a result, Clunie had to dig through the numbers: “Most of the academic evidence shows that short-selling in aggregate helps with price discovery and market liquidity, and is thus beneficial for the working of markets. But that’s an aggregate finding. There are instances where short-selling can be abused to make markets worse – for example, in creating intra-day liquidity crises (and there are some academic papers that demonstrate how this can arise).”

    For Finex’s Tselentis, it is not so much investors but company management that takes issue with shorting. “Managers exploit the bad press surrounding shorting to excuse troublesome performance, whilst Investors understand that without an efficiently run system they would struggle to meet their goals of both impact and a reasonable return. The unethicality of shorting as an argument is deployed by company boards to excuse their bad share performance. The fact is that no good company has ever been damaged by shorting, the only thing an increase in shorting can be accused of doing is diverting people’s attention from the fact that there might be an underlying company problem. Shorting is the symptom of an event caused by bad management, fraud, poor capital structure, structural problems in an industry and, or technological obsolescence.”

    Norwegian-based Jarle Birkeland, CIO at Alchemy Trading, takes a more empathic approach. “We have to remember that corporations and listed companies essentially are made up of groups of people coming to work every day, putting in their best effort to bring a product or a service to the market, wanted and needed by consumers. If organised well, these people cooperate and support the mission, vision and goals set out by the management, governed by the owners through the board. On a very basic level, you could argue that shorting a stock (a corporation) is a form of a counteract or an obstruction-like action against that very effort towards prosperity, growth and value creation. However, we don’t have to drill deep to see why the concept of shorting a stock is actually a long-term necessity and of high importance from a societal and ethical perspective, to everyone!”

    A democratic process

    “Shorting a stock to us is actually nothing different than the concept of having a democracy – letting diverged opinions through, and eventually let the majority elect their trusted leader and representatives – or decide the price of the stock,” states Birkeland. “If opinions are one-sided and if there is no room for diverging opinions and meaningful debates, greed will lead and push the crowd too far out on one side, eventually resulting in misery and suffering for all. The Dutch Tulipmania in the 1630’s, the Japanese Real Estate Crash at the end of the 1980’s, the US Dot-Com Bubble early 2000, or the big meltdown in global asset prices in 2008/9 are known examples of imploding bubbles that had repercussions far broader than for the directly involved market participants. That is why we are in the camp supporting an open market debate where you got diverged asset class positioning, arguing it contributes long-term to less crash-prone markets with broad negative economic ripple effects.”

    “So we need them all,” Birkeland continues, “from the long-term holders of stocks to those buying and selling every day, those that only participate to the upside, to those that believe stocks are too expensive or mispriced and are willing to position for the downside. This symbiosis is to us what makes a market and contributes to the vital function the stock market represents in a modern economy – connecting innovative ideas with those having the capital to bring them forth, creating growth and jobs. From both a classical and neoclassical economic theory standpoint, we all try to maximise profits, the utility and thereby happiness, shorting is just a natural piece in that big puzzle.”

    “Wasted capital is as bad as wasted energy,” proposes Tselentis, as he concurs on the idea that shorting is part of a democratic market. “We believe that shorting is ethical as it allows markets to perform efficiently. Ultimately the share price is nothing more than an indication, using a single number, of what the collective thinks the company is worth. The collective can hugely underestimate or overestimate this value. There is nothing unethical in deciding that the collective has overvalued a share and putting in place a strategy that will profit from the normalisation of such a price. Nobody would argue the contrary with an undervalued share, why the differentiation? Thus, short-sellers act as part of the price discovery mechanism. They enable prices to find their price equilibrium; they help capital flow efficiently to companies that deserve it, and they allow investors to pay a fair price.”

    For both Gavelin and Tselentis, the very process behind the implementation of short positions ensures a balance of interests. “When an investor wishes to short a share,” says Tselentis, they must first receive permission from their broker, who in turn must find a shareholder willing to lend their share to the shorter,” he explains. “Thus, if a company’s shareholders felt that shorting was not in their best interests in terms of both the extra yield generated from the lender’s fee and the efficient price discovery mechanism that the process creates, then they have the option of not lending the share. Because this process can only exist with a willing stock lender, it would suggest that shorting is acceptable to shareholders.” Gavelin agrees but pushes the argument further: “We do not see any ethical issues. We agree with the owner of the shares to borrow their shares, and we pay them interest to compensate for this. In some situations, you could argue that it is unethical for the owner to lend the shares, but that is a different question.”

    Pragmatically, Clunie helps us quantify the issue: “I believe that shorting is ethical most the time as described earlier, but it can be abused. I’d guess that 90-95 percent of the time, it is helpful for markets; while 5-10 percent of the time it is unhelpful. I think that many financial regulators understand this too.”

    Creative destruction

    Our managers agree in general that shorting can be useful for both hedging and generating alpha, even if they come at it from slightly different angles, especially when it comes to integrating shorting into sustainable investment principles.

    Clunie uses shorting primarily to express a negative opinion on a stock price. “I always aspire to make a profit for my clients,” he says. “but this can be difficult to achieve. I certainly aim to add value in some way (relative out-performance, say, whilst reducing market exposure at the same time).”

    At Adrigo: “The primary reason for shorting,” says Gavelin, “is that it enables us to create strong risk-adjusted returns and that the short positions make it possible for us to create positive returns in bear market periods. For us, I would say it is a combination of hedging long positions and generate stock-picking alpha on the short side.”

    Tselentis gives us a practical example and tells us how shorting fits into the industry that he specialises in. “We fundamentally believe in cleantech,” he says, “and will always have a positive outlook on the sector. However, we also need to protect the Investors’ hard-earned capital from shocks and volatility. Regarding Alpha generation, we ascribe to the notion that there is a continuous process of creative destruction, as described by Joseph Schumpeter. This affects companies in both emerging industries and mature entrenched industries.  Creative destruction describes a process where multiple companies in a new sector, such as mobile phones in the nineties, compete for dominance. Eventually, some companies dominate the sector whilst many others collapse or are bought out.  The companies that collapse create Alpha that is uncorrelated.  This uncorrelated Alpha, in turn, is used to hedge a portfolio and lower overall portfolio risk.  In our case, we lower the risk of cleantech investment from a beta of 1.5 to 0.4.  We lower cyclical drawdowns from 65% to 15%. Thus, we see that shorting can make a very volatile sector such as cleantech far less risky.”

    Drilling down the investment process into sustainability principles, we see how putting longs and shorts in the same basket may lead to undesirable effects, but keeping things simple can also be helpful. Gavelin’s approach is very straightforward: “We have decided to not invest in companies that base their revenue stream on production and sales of tobacco, weapons or alcohol and we also exclude betting companies. We apply the same principles to the short side as the long side.”

    Clunie’s view is more cautious regarding stock exclusions, and his style is more hands-on: “Most studies that I’ve read demonstrate that ‘exclusions’ should hurt the risk-adjusted returns of a portfolio, but often make little practical difference when compared to other active approaches. When I invest, I prefer to integrate governance and sustainability issues into my stock level analysis, rather than separate it and create top-down exclusions (but that’s just my approach!).”

    However, Tselentis takes the opposite view: “We believe in negative exclusion as the most efficient way of reflecting an investor’s or society’s ethics and values.” He then offers some historical perspective and makes an important distinction between exclusion lists. “Initially ‘first-generation’ exclusion lists comprised companies whose conduct was so ethically severe that traditional financial metrics were immaterial (e.g. companies that have been excluded due to their use of child labour, breaking current environmental laws, human rights abuses, etc.).  With the realisation that stranded asset risk was a real issue driven by the obsolescence of carbon energy sources, ‘second-generation’ lists appeared, with companies involved in coal mining, tar sand-based oil production and utilities that produce a significant amount of their energy from coal. These exclusions reflect financial risks as wells as environmental risks.”

    “The distinction between the two generations of lists hinges on the appreciation that shorting gives benefits to the owners of potentially unethical companies both monetarily, (paying the fee to the shareholder lender) and provides an increased price discovery mechanism (liquidity). It is for this reason that we do not short companies excluded in the ‘first generation’, whose practices we have identified as unethical. However, companies that are on the second-generation exclusionary list because they are on the wrong side of technological progress, and that are obsolete because of structural issues driven by technology, can be shorted because it is in our investor’s interests.”

    In general, for Birkeland, sustainable investing, in the long run, should become a natural consequence of the democratic process he proposed earlier: “We recognise the hot topic of RSI and ESG investing and support its intentions,” he says. “Looking further ahead, we think it should be unnecessary for investors or funds to apply extra filters like these to their listed stock universe, as the selection already should be made at a much earlier stage. If you get marked as unethical, why should you even have the right to life and deserve a listing? Over time we think this process will adjust itself. That’s actually one of the great things about capitalism… if your vision, mission and objectives get more ‘thumbs down’ than ‘thumbs up’, it won’t get funded and experience success. Only those that can demonstrate good-hearted ideas get a chance to evolve and prosper.”

    This article is part of the Special Report on Equity strategies published by HedgeNordic – read the entire report here

    Aline Reichenberg Gustafsson, CFA
    Aline Reichenberg Gustafsson, CFA
    Aline Reichenberg Gustafsson, CFA is Editor-in-Chief for NordSIP and Managing Director for Big Green Tree Media. She has 18 years of experience in the asset management industry in Stockholm, London and Geneva, including as a long/short equity hedge fund portfolio manager, and buy-side analyst, but also as CFO and COO in several asset management firms. Aline holds an MBA from Harvard Business School and a License in Economic Sciences from the University of Geneva.

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