Short sellers are rarely popular, but their job is important. As I discussed previously, virtually all empirical evidence supports the conclusion that short selling plays a positive role in the process of efficient price discovery.
Yet while the verdict on short selling's value to capital market functionality is clear, the jury is still out on whether short-side strategies can actually help deliver market-beating returns – especially in today's seemingly unstoppable bull market.
A niche profession
Many active investors, especially those with a value-oriented mindset, dedicate considerable time to the search for cheap stocks to buy. Far fewer spend their time looking for overly expensive stocks to short against. That is in large part because short selling demands a lot more from investors, who must often dig beneath the surface of companies' financials and management statements in order to get at the real truth. Few institutional investors or Wall Street analysts do so on a regular basis. The work of shining a light on the issues buried beneath the surface of public companies is often left to smaller specialist firms, such as Muddy Waters Research, as well as to intrepid individuals like Edwin Dorsey.
The relative lack of mainstream attention paid to the issues and red flags that attract short sellers, both among financial professionals and the financial media, means there may be market inefficiencies to exploit. Many fund managers argue that shorting can result in excess returns, known as "alpha" in the parlance of investment professionals. But a short seller has to work for their alpha. In his book, "Value Investing: Tools and Techniques for Intelligent Investment," James Montier extolled the virtues of short sellers, declaring them to be "among the most fundamental-oriented analysts" in the investment world:
"These guys, by and large, really take their analysis seriously (and so they should since their downside is effectively unlimited)."
Many investment strategies incorporate some aspect of shorting in an effort to enhance overall performance. Indeed, it is a core premise of the long-short strategies that gave hedge funds their name, and remains a popular thematic framework for investment funds to this day.
Thus, shorting can serve as a hedge as well as a means by which an informed investor can exploit the market's informational asymmetries.
A patchy track record
While many investors contend that shorting can work as a market-beating strategy, or at least enhance a portfolio's alpha when incorporated into something like a long-short strategy, the empirical evidence is mixed, when it is available at all. Indeed, short side alpha (or lack thereof) is difficult to measure at all, as FBS Management's Gregory Frith pointed out more than a decade ago:
"Biased Long/Short Equity strategies can take huge bets ranging from 100% long to 100% short exposure at any given time. Moreover, leverage ratios can change on a daily basis to maximise the best absolute return scenario possible. Even those managers utilising some constraints often take huge sector bets. In any of these scenarios, it is nearly impossible for an investor to quantify how the returns are being generated. Did the manager time the market correctly, own the right sectors, short the proper individual stocks, and/or utilise effective leverage? To efficiently address these questions, an investor would need daily audited return and trading summaries. Also, these issues do not even begin to address the subject of what benchmark to use."
Moreover, shorting seems to have only gotten more dangerous in recent times. The wild ride and brutal short squeeze of GameStop Corp. (GME, Financial), for example, even caused some to question whether traditional shorting practices can work anymore, as BloombergQuint reported in January:
"The latest assault on Wall Street short sellers has a long tradition, dating back to, well, at least Napoleon. 'Treasonous,' he called them for betting against government securities. They survived that and numerous other attacks over the next several centuries. But the GameStop uprising could mark the end of an era for the public short -- the long-vilified folks who try to root out corporate wrongdoing, take positions betting a stock will fall and then wage public campaigns."
Hordes of retail investors, combined with strengthened government backstops for capital markets, have made shorting a lot harder of late. It has even caused some of the best-known short sellers, such as Andrew Left, to despair and abandon the short-side research services his firm, Citron Research, had provided for two decades.
A glimmer of hope
Not all famous short sellers have given up. Herb Greenberg of Pacific Coast Research, for example, opined that shorting may be "on a brief hiatus" but is far from dead. Fahmi Quadir, who was one of the principal short-sellers who helped bring down Valeant Pharmaceuticals, has likewise refused to give up the fight.
Still, when one sees the dynamics at play in today's market, it is hard to conclude that shorting is a safe strategy at present. However, I believe it can still work, even if the market has been more forgiving of corporate malfeasance than in times past. It may be tougher, but it is still worth the effort. After all, in the battle between reality and fantasy, reality always wins – even if it takes longer than it used to.
Disclosure: No positions.
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