GameStop: the ethics of short sellers

The global media has recently been entranced by a battle between retail traders and hedge funds over the US computer game store, GameStop. It has also shone a light on a practice that makes many people feel uneasy: “short selling”.

To assess the ethics of short-selling, we need to consider the actions of different short sellers rather than short selling as a principle. In general, those actions reflect their motivations, which can be broadly split into four categories:

Stock picking on steroids

The stock picker on steroids search for overvalued stocks or stocks which are facing structural headwinds that are not yet fully reflected in the price. “Shorting” these companies is a more direct way to position for their anticipated fall in value towards more reasonable levels than would be possible in a long-only portfolio.

An area of emerging interest is funds with a sustainability focus which short stocks. Some investors prefer to exclude certain sectors from their portfolios such as tobacco stocks. However, a more extreme approach would be to take an outright short position in these sectors, or in companies with poor (or deteriorating) sustainability credentials more generally.

The activist shorter

Rather than assuming that the market will eventually price companies fairly, the activist shorters seek to force the issue. They often try to maximise publicity on their reasons for believing a company is overvalued. On one level, this can be applauded. The forensic analysis conducted by some short sellers can unearth previously underappreciated issues and in making these public, they can force management to deal with them.

However, the more extreme activist shorters are the ones that give the practice a bad name. Some have been guilty of spreading unfounded and malicious rumours in the press, a consequence of which is that they can earn a profit on their trade but push otherwise healthy companies into financial difficulties. Even if these companies manage to prove the accusations false, the short seller may be long gone by that stage, having booked a profit on their trade and left a trail of devastation in their wake.

The risk manager

These people use shorting to control risk in their portfolios and express their views on particular stocks in as pure a way as possible. Let’s say an investor wants to express a positive view on a particular stock relative to the market. One way to do this would be to buy the stock. However, then, if the market falls, that stock could fall too. If it falls by less than the market the original thesis would be proven correct but that would have been somewhat irrelevant as it would have been swamped by the decline in the broader market.

One way to avoid this is to buy the stock while also taking out a short futures position on the market. Then the return would be the difference in return for the individual stock and the market. In our example above, the trade could yield a profit, even in a declining equity market. Shorting allows a cleaner expression of a view on a particular stock or sector while also reducing volatility and risk of loss. The approach does not affect the health of individual companies, is typically low profile and doesn’t raise ethical concerns in our view.

The emotionally-detached trend follower

The trend follower seeks to profit from trends in markets, buying when markets are rising and shorting when they are falling. These strategies are normally highly quantitative and systematic in nature, powered by powerful computer algorithms. Their emotionally detached nature means they cannot be accused of attempting to drive down prices. It is all about maths.

An unfair reputation

In summary, short selling has an unfairly bad reputation. Rather than avoiding the practice, investors, especially those who are more ethically minded, should ensure they understand its potential uses in a strategy and how its practitioners intend to behave. It can bring about significant benefits, both to investment performance and standards of corporate governance. Some short sellers are unethical but short selling itself is not.