Professional investors can review published thought leadership and market updates from the Argonaut Investment Team.

‘In defence of short selling’

Until recently, we have been in a bull market which no one wanted to ban. Now after losing their clients a lot of money, we hear some fund managers joining the usual suspects in announcing that short selling should be outlawed, as if shorts have spread a virus. Suddenly it is unfair that share prices go down as well as up.

There is no evidence that short selling destroys good businesses or is currently damaging the UK economy. Companies go bust not when their share price falls but when they run out of cash. Shorts do not drive share prices into the ground: in order to realise a profit a short seller must always close their position whilst there is still market liquidity. If stocks fall precipitously, a good short seller will normally be buying not selling. Over the past few days I have been closing short positions and buying high quality stocks at knock-down prices. Given that the wider industry is currently dealing with redemptions, we might surmise that any patriotic buying supporting the market is in fact being done by the pantomime hedge fund villains of the Mayfair.

Short sellers do, however, often unmask fraudulent management and expose poor business models. The recent collapse of NMC Hospitals, for example, was as a direct result of bespoke research carried out by short sellers which, despite the vehement denials of the company management, proved to be inaccurate only to the extent it underestimated the scale of fraud and wrongdoing. NMC has in fact been an astonishingly brazen multi-billion-dollar fraud. Without short sellers these crimes may never have come to light .Even now, with the perpetrators having fled to India, the company’s assets in Arabia and the stock still suspended from trading in London, we do not know which authority will hold the legacy management to account . If there are no short sellers to play the role of market vigilante, we would inevitably have a more dishonest stock market. In the absence of shorts, capital would be allocated less efficiently and over the long-term economic growth would suffer.

Short selling should in fact be encouraged by regulators in a crackdown on stock market fraud. There are many other companies on European stock markets which display more red flags than you would see at a communist party rally but have not yet had their day of reckoning. Too often European regulators have given the impression that holding company management to account was somehow against the national economic interest. Witness the extraordinary ban put on short-selling German payment outfit Wirecard last year following diligent and responsible investigative journalism at the Financial Times. The company responded by appointing an international accounting firm to provide a third-party audit: we are told that although the report is still not yet finished it will nevertheless be favourable to management. What exactly management has instructed to be cleared of is not and may never be clear.

We have recently witnessed the steepest falls in equity markets since 1929. This has highlighted the folly of diversification through exclusively long only equity products which have all fallen off the proverbial cliff at the same time. It has also highlighted that most savings products are dependent on positive economic outcomes, but that people often need access to their savings exactly at the weakest point in the economic cycle. Without any ability for fund managers to hedge their long book through short selling, fund buyers would be further unfairly corralled into equity products that all rely mostly on market beta for their returns.

Active fund management has struggled to justify itself in the face of the passive industry providing cheap exposure to market beta. These problems can only be compounded by the return profiles of equity funds at most large asset managers which we now see compete with the passive industry by just offering more expensive beta, cleverly polished. Funds like mine which hedge their market exposure in order to be genuinely uncorrelated have often been shunned largely because in bull markets short books will be a hand break on overall returns. But in a few short weeks the market has plunged back to levels last seen in 2012, whilst our fund has powered to fresh highs, beating the market return by 50%, again demonstrating the value of a positive uncorrelated return. At all times our short book has been smaller than our market exposure, used as a hedge, rather than a directional negative bet. We generate returns from both long and short alpha rather than directional beta. This has confirmed that the future of the active fund management industry will not be in packaged beta but rather in more alpha: in fact, double alpha

Barry Norris
Fund Manager of the Argonaut Absolute Return Fund
March 2020