Should short selling be banned?

Long investors hate it and company bosses despise it. So why does the market allow people to barrack for misery?

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ASX share price trading halt represented by serious woman putting hand up

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Very few things get people fired up more than short selling.

To many investors, it’s a mechanism available only to elite professionals that profit from the misery of others.

And it’s not just retail investors that feel this way.

“Every company has a team of people working hard to make it a success,” Frazis Capital Partners portfolio manager Michael Frazis told The Motley Fool.

“It’s infinitely more rewarding to spend your days being positive and supportive of other people.”

The angst against short selling really climaxed the past week as the GameStop Corp (NYSE: GME) saga came to a head in the United States.

That chaos was triggered by a group of retail investors who mobilised to wreck hedge funds that were financially rooting for the retailer to sink.

Those that are running publicly listed companies also understandably hate shorting.

“Short selling should be illegal,” said Tesla Inc (NASDAQ: TSLA) boss Elon Musk on Twitter in 2019.

Then as the GameStop frenzy took place last week, he reiterated his disdain.

“U can’t sell houses u don’t own. u can’t sell cars u don’t own. But u *can* sell stock u don’t own!?” he tweeted.

“This is bs – shorting is a scam. Legal only for vestigial reasons.”

In Australia, tech companies like Tyro Payments Ltd (ASX: TYR) and WiseTech Global Ltd (ASX: WTC) have had their problems too with short sellers.

If it’s so bad, should short selling simply be banned?

The defence for short selling

According to UNSW Business School associate professor Mark Humphery-Jenner, shorting has an important function in a free and open market.

“Short selling is fundamental to ensuring correct market prices,” he said. 

“Short sellers make market prices more efficient and incorporate more information more quickly into market prices so that prices reflect firms’ true values.”

Shorting ensures what’s labelled “market efficiency”, Humphery-Jenner added. It assists companies to raise capital by providing confidence to investors that they’re not outrageously overpaying for shares.

“Short selling is not manipulative per se, because the costs involved in manipulating prices through shorts are often prohibitive, and regulatory scrutiny is ample enough to prevent it.”

Frazis and his fund used to short until they shifted to long-only a couple of years ago. He agreed that shorting is an expensive activity. 

“It costs a fortune to run a short book. Shorts can cost 2% to 4% to hold a year, and sometimes a lot more,” he said.

“We plan to be in business for 30 years, so that adds up to a staggering amount. The real money in life is made by owning successful businesses for extended periods of time.”

But doesn’t shorting hurt companies and workers?

Shorting and short reports can certainly be stressful to the target business and its shareholders.

But Humphery-Jenner pointed out the act of shorting itself doesn’t hurt the business or people.

“Short sellers do not impact corporate fundamentals. Short sellers do not cause company bankruptcies. Short sellers do not cause lower earnings. Short sellers do not cause unemployment,” he said.

“Indeed, it is not even clear that the presence of short-sellers is per se related to lower returns.”

He added short selling doesn’t “generally place long term downward pressure on [stock] prices”.

“Rather, it is plausible that because short sellers can be active, people have more confidence in prices, causing more pricing accuracy and higher returns.”

Even if it has no long term financial impact, there’s no doubt short selling can feel icky to many.

Frazis told The Motley Fool that it’s not a sustainable investment strategy anyway.

“We’ve noted before that when bearish investment professionals heavily short a widely loved company, the love tends to win out,” he said.

“Shorting changes your mindset. It brings out your cynicism. You do well when others do not.”

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Tony Yoo has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of and recommends Tesla. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of Tyro Payments. The Motley Fool Australia owns shares of WiseTech Global. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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