Short sellers get a bad rap, but they actually fulfill an important role in the market ecosystem. In a 2010 interview with the Financial Analysts Journal, Baupost Group founder Seth Klarman (Trades, Portfolio) explained why he believes they are necessary.
Policing the markets
Klarman was asked whether he thought that short selling by big hedge funds constituted market manipulation. He strongly disagreed with this idea. Even though Baupost does not sell securities short, he still believes that short sellers fulfill an important role in the market:
"My experience is that short sellers do far better analysis than long buyers because they have to. The market is biased upward over time - as the saying goes, stocks are for the long run. And just by the nature of what they do, the Street is biased towards the long side, and so there is more low-hanging fruit on the short side. Short sellers are the market's police officers. If short selling were to go away, the market would levitate even more than it currently does."
So Klarman does not believe that short selling should be banned. If it were, he thinks that there would be far more scams and fraud as companies prey on unsophisticated investors (as well as sophisticated ones). So many actors in the market have a strong interest in seeing stock prices rise: index funds, retail investors with 401ks and IRAs, the financial media (who make more money if a lot of people are interested in investing, which usually happens during bull markets) and governments all want markets to go up. With such a strong bias to the long side, it is important to have at least some balance.
Banning short selling is an idea that resurfaces during any financial crisis. No investor, amateur or professional, wants to admit they have lost money because of a mistake in their process. It is much easier to blame some boogeyman for your losses, and who better to blame than people and firms that are profiting from the same events that are causing your portfolio to suffer?
A ban on short selling would actually cause stocks to fall. The reason for this is that many of the largest institutions in the market use short selling to hedge themselves against a potential decline in equity prices. If short selling is banned, then many of these institutions would be forced to liquidate their long positions, either because their mandates do not allow them to be unhedged or because their internal risk management systems advise against it. So proponents of a ban on short selling should be careful what they wish for.
Read more here:
- Howard Marks and Seth Klarman: The Difference Between Cycles and Timing the Market
- Advice From Li Lu
- The Value Investor's Handbook: Understanding Chapter 11 Bankruptcy
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