Why Short-selling is a Force For Good.

Posted on 13/08/2010

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No activity within finance appears to generate more negative press than short-selling, the practice of borrowing securities and selling them (ie. in order to benefit from an anticipated price decline). A recent Guardian commentary described short-sellers as “amoral speculators”, “wreak[ing] their own havoc by magnifying and accelerating events, inflicting more pain on innocent citizens in the process.” The article was specifically discussing Germany’s proposals to ban naked short-selling of credit default swaps in an attempt to prevent politicians being “trampled by unaccountable and unelected traders, acting purely for their own profit and with no thought for the wider social good.”

However, academic evidence continues to build that short-selling is in fact beneficial to financial markets as it allows information (ie. analysis and research which has been carried-out at the expense of private institutions and individuals) to be incorporated into the market price of the security in question, which is then in the public domain. This information can then be used by everyone, including the many of us that implicitly free-ride on the investment analysis of others by investing in index tracker funds. As an investor, making monthly pension or direct-debit savings payments into a tracker fund, would you rather overpay for stock in a company which is likely to run into trouble, or would you rather pay a fairer (and lower) price that reflects the work and investment decisions of short-sellers.

This latest academic research is a piece entitled “Vultures Circling Overhead: Does Short Selling Tell the Future?” by Christo Ferreira, Udomsak Wongchoti and Fei Wu of Massey University and in it they find “a lead-lag relationship between securities which experience high levels of short-selling and those that do not. This is based on evidence that short-selling increases the speed with which information, especially negative information, is absorbed into prices.” This means essentially, that adjusting for all other factors, stocks with higher levels of short-selling tend to lead the movements of those with less short-selling, in turn implying that short-selling allows information about the broader economy (and the sector in question) to be included in stock prices. This information benefits all users of the stock market, and in particular those that invest by using index tracker funds which free-ride on the investment analysis of others. In conclusion, short-selling could be argued to have positive externalities.

Cautious Bull would therefore suggest that politicians begin to pay a little less attention to sensationalist newspaper comment pages and a little more attention to the work of academics.

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