- Capital Gains
- Short-Sellers Rarely Conspire (And It’s Mostly Helpful When They Do)
Short-Sellers Rarely Conspire (And It’s Mostly Helpful When They Do)
They Do, However, Get Involved in Conspiracies
In the aggregate, the world's global exposure to equities is 100% long; every share has an owner, and every short-sale transaction creates an offsetting long and short position (if 10% of a company's shares are sold short, then the long side owns 110% of shares outstanding). And since the stock price represents the earning power of companies, and that earning power tends to go up when the world gets richer, the population of equity investors is, over time and on average, making an optimistic bet about the future. Globally bad news—recessions, wars, pandemics, natural disasters—tends to make them worse off.
But there is an exception: short-sellers profit from bad news, whether it’s the generic global kind described above, or it’s the specific kind about the companies they're betting against. Which, as you might imagine, makes them relatively unpopular. (The head of the NYSE called them "icky and un-American," and Elon Musk says short selling should be illegal.) And, of course, if you spend any amount of time on r/wallstreetbets, you'll see plenty of claims that short-sellers are conspiring to destroy the value of honest companies, and the savings of everyday investors.
To an extent, this is understandable; if you think of other jobs that mostly benefit from bad news, it's not an especially high-status bunch: divorce lawyers, repo men, morticians, and pawn shop operators all fit the profile, and none of them are going to show up on a list of the most admired professions. But, like those professions, short-sellers also serve a useful purpose: since the world is net long stocks, there's necessarily more attention paid to figuring out which ones should go up than which ones should go down—but both questions are worth answering.
It's useful to start with a rough taxonomy of short sellers, because they have different motivations: first, pure hedgers put on short positions as part of a trade that aims to have minimal net exposure to a given stock. An options market-maker can have substantial overall short positions, not a single one of which implies a bet against a company; these positions will arise when the option trader either buys cheap call options and hedges with the underlying stock, or sells expensive put options and, once again, hedges. Because this kind of market-making is increasingly a scale business, such investors will show up on lists of the most active short sellers, but their business model isn't sensitive to individual positions and doesn't require having a fundamental view.
Second, some investors, frequently found at pod shops, use shorting because their mandate is to pick stocks within a given set of companies, and their risk level requires them to balance long positions with short positions. These investors, too, will have substantial short positions—a multi-strategy fund might be levered 6- to 8- to one, so $1 in assets under management probably represents $3 to $4 in long positions offset by $3 to $4 in short positions. A look at the assets under management for the biggest firms should indicate that these funds are massive participants in shorting. But they are generally not shorting stocks solely because of long-term views; their model is based on near-term changes in sentiment. So the short thesis is less likely to be "this company is a scam and it's going to zero," and more likely to be "this company's second-biggest customer sounded less optimistic at the conference last week than they did when they reported earnings a month ago, so guidance is likely to be a little light compared to expectations and the stock will probably trade down 5% in the next two weeks as more people update their channel checks and figure this out."
And third, there’s a handful of investors who spend all of their time on short-selling research, and tend to focus on companies that are either ludicrously overvalued or are potentially fraudulent. Some of these investors run funds, but many of them operate independent research firms that partner with outside investors. The usual approach is: find a target, produce an absolutely devastating writeup, share it with the partners, and split the profits when the stock drops upon the report's release.
This last group is the closest you'll realistically get to short-sellers conspiring.1 But this is just the equilibrium—it's hard to raise money for a short-selling fund, especially at times when opportunities are most abundant. When any dumb idea can get a high valuation, there are lots of short opportunities—but a bull market in dumb ideas is a bear market in smart ones, such as betting against these dumb ideas.
These kinds of ideas are intermittent, and require an uncertain amount of research. The optimal allocation for a dedicated short-selling fund that only looks for great ideas would be 100% cash 90% of the time, and then 50% of the fund in put options when it's time to make a trade. But that doesn't fit in with anyone's investment mandate.
Having research shops that are dedicated to finding good ideas, and pools of capital that get the right position size for these ideas, means that instead of a portfolio that's either underweight or massively overweight on one idea, there's a portfolio that's typically chugging along with more conventional strategies, and that is every once in a while making a sizable but not irresponsibly large bet on one good one.
So, short sellers do sometimes conspire, though that's more a function of how hard it is to raise money than because of the efficacy of conspiracies as such. And this is a good thing. A short-seller is a professional conspiracy theorist, who believes They're Hiding Something, sets out to prove it, and expresses this view with both a manifesto and some put options. The bad short sellers go out of business, and the good ones put bad companies out of business. (Or, in cases where the stock is merely overvalued but not actually a scam, they at least ensure that capital isn't being misallocated to bad companies.)
This is a great service for the rest of the market. If you want to be safe buying index funds, you should be delighted that people periodically strike it rich by identifying bad companies and obliterating their market value, kicking that bad company out of the index. Any diversified investor who doesn’t undertake the kind of painstaking research short-sellers do—interviewing ex-employees, running FOIA requests to look for under-the-radar investigations, carefully reading old documents to look for disappearing disclosures, running background checks on board members, visiting overseas customers to see if they’re really companies or fronts—faces the risk that they’ll invest in a scam. Fortunately for them, there’s another cohort of investors who are paid to fix this.
Read More in The Diff
The Diff has covered short-selling frequently; it's an informative topic because it illustrates both how money gets managed and how companies get mismanaged. It's also funnier than average—telling a joke is all about setting up an expectation and then suddenly subverting it. (Surprise! Wirecard's profits were fake!). Some relevant pieces:
Heuristics for spotting cheating ($): the statistical distribution of cheaters will look different from the distribution of honest winners.
The economics of selling short-selling ideas ($): an elaboration on the short-selling research ideas above, with further thoughts on why professional short-sellers don't fit in at regular funds.
It's hard to make money shorting worthless stocks ($): This piece advances the idea that fraudsters have an "invisible line of credit," because once they're willing to break the rules, they can cover up some fraud by committing even more fraud.
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1. The pure hedgers generally don't have any single position that's all that material, and since the hedging is easier to execute than the trade they're hedging, it's the least interesting part. Investors in pod shops do trade ideas all the time, but it's slightly riskier to share short ideas than long ones, both because good shorts are harder to find and because a short squeeze is always a risk.
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