Wednesday, February 24, 2010

It's Fact - Short Sales Don't Drive Share Prices Down

At last - a piece of research has been published that examines the relationship between the level of short sales and adverse share prices.

Writing for the newly re-launched London-based Alternative Investment Management Association Journal, Emily Stewart has lead-authored the paper "Short Selling Impact on Australian Stock Prices". (Note: the author of this blog post is also a co-author on the paper).

One of the side benefits of the Australian Securities and Investments Commission's conservative approach, in which the ban on short selling was applied for an extended period compared to other jurisdictions, was that it delivered a rich data set of 127 observations.

Stewart collected the Gross Short Sales data that was published each day and applied her analysis to the S&P/ASX20, which represented almost 60% of total All Ordinaries market capitalisation. She was able to distinguish between the so-called financial stocks and the non-financial stocks, as the periods each were banned differed.

Stewart's results either debunk the conventional wisdom that declining share prices are associated with short selling or indicate that the Gross Short Sales data, for all the effort required to collect it, is a poor measure of the impact of short selling.

Tuesday, February 02, 2010

Australian 2010 Intergenerational Report

The Australian Government has released its well foreshadowed Intergenerational Report titled "Australia to 2050: Future Challenges". The Overview runs to 22 pages while the full document is 190 pages (1MB). No real surprises here, but it provides a good basis to reflect on the policy choices facing Australia.

The primary driver of the outcomes contained in the report are demographic in nature ie the number of working age Australians supporting each retiree is expected to fall from 5 people today to 2.7 people in 2050. Without any action this will result in a deteriorating fiscal position to a deficit of 3.75% of GDP. Capping real government spending growth to 2%, reduces the fiscal gap to 2.75%.

The key to addressing this imbalance (and thus maintaining living standards) is productivity. Unfortunately productivity growth has declined in the past decade to 1.4% compared with 2.1% in the 1990's. The report highlights the benefit of raising productivity and points to increased spending on education, infrastructure (eg National Broadband Network) and regulatory and tax reform as sources of productivity.

The main source of growth in spending relates to health care, driven by an older population and resulting pressure on services, as well as demand for higher standards of care and technology innovation. Spending on health is expected to almost double as a percentage of GDP from today through to 2050 and account for two thirds of the increase in government spending over the period.

Climate change has listed as a threat and policies designed to lower pollution and increase use of renewable energy noted. However, in a world where energy costs will necessarily be higher than when relying on fossil fuels, it will be difficult to deliver the productivity gains required to address the looming fiscal gap and maintain living standards.

Migration policy is the elephant in the room. While global demographics are difficult to turn around quickly, a small country such as Australia can alter net migration as a matter of policy and increase the proportion of working age Australians to retirees.

Tuesday, December 01, 2009

Short Sales Bans - Help or Hinderance?

Now that the dust has settled on the action taken to limit short selling during the financial crisis, The Centre for Economic Policy Research has prepared a report that examines how effective the bans were.

The Centre sifted through the evidence generated by the various regime changes to investigate the impact of the bans on liquidity, price discovery and stock returns.

Since the bans were enacted and lifted at different dates in different countries, and in some countries applied to financial stocks only, they were able to identify their effects with panel data techniques ie data containing observations on multiple phenomena observed over multiple time periods.

In summary, they have concluded that the bans:

  1. were detrimental for liquidity, especially for stocks with small market capitalization and high volatility;
  2. slowed down price discovery, especially in bear market phases, and
  3. failed to support stock prices

Friday, October 02, 2009

Short Selling Disclosure Regulations

Financial Services Minister Chris Bowen has released Short Selling Disclosure Regulations attached to the Corporations Amendment (Short Selling) Act 2008. The Regulations require that share investors report covered short sale transactions to brokers as is currently the case, and in addition, effective 1 April 2010, report positional short positions to ASIC which will be aggregated and reported with a 4 day lag.

The acknowledgement of the value of positional reporting is commendable. However, retaining the transactional reporting requirement is difficult to understand given the cost involved and in view of the fact that it is partial and misleading (see earlier post).

The announcement is silent on how the positional information is to be conveyed, whether it is direct or via prime brokers/custodians as discussed in the 6 March Treasury Consultation Paper. How will foreign investors be enforced to provide data and how will ASIC achieve the aggregation task?

All this effort and expense to justify a mechanism designed to report positions that according to the Australian Treasury represent an upper limit of 4% of total market capitalisation. Once a record of short positions is established and proper analysis is conducted will the cost of this dual reporting approach be seen to be justified?

Thursday, October 01, 2009

The 7 Habits of Highly Suspicious Hedge Funds

In a post-Madoff world this blog post from Rick Bookstabber titled "The 7 Habits of Highly Suspicious Hedge Funds" makes good reading.

It confirms my thinking that hedge funds will fall into two broad groups going forward. First, those that operate under a veil of secrecy and use leverage and sometimes unlisted securities. And then there are those that rely on an open and transparent process with listed securities and no leverage.

The key safety factor for investors is the separation of custody and administration from investment management. Not just Chinese wall separation, but real separation. In Australia, the role of independent Responsible Entity provides that separation for retail investors and other investors participating in an ASIC registered Product Disclosure Statement. For institutional investors using managed accounts, the role of custody and investment management is clearly separated.

For investment managers that are also Responsible Entity and perform custody and administration functions, the burden of ensuring separation of roles is necessarily greater.

Funds that have open and transparent processes, that don't require leverage to produce returns and are prepared to publish holdings (even with a lag) will be more likely to gain the confidence of investors.

Friday, May 29, 2009

ASIC Removes Short Sale Ban

The short selling ban on Australian listed financial securities was finally lifted by the Australian Securities & Exchange Commission (ASIC) effective 25 May 2009. The ban on financials extended beyond the two month ban placed on all securities that was lifted on 19 November 2009, because of concerns about systemic risk associoated with financial securities.

With some stability resuming in financial markets, and presumably assured by the benefit of the new reporting on gross short sales introduced on 19 November 2009, ASIC weighed up the market efficiency benefits in lifting the ban.

ASIC reserved the right to reimpose the short sale ban without consultation if they deemed it necessary. Disturbingly, ASIC referred specifically to activity by "hedge funds and similar institutions" in the same paragraph, suggesting that hedge fund activity was somehow a potential threat to an orderly market. Yet there is no such evidence that short selling does have an adverse impact on share prices, let alone that hedge funds are specifically involved in such activities.

Still on the horizon is clarification about the the form of short selling reporting that will be adopted going forward and whether the partial and potentially misleading current gross short selling regime will be persisted with.

Sunday, March 08, 2009

Australian Treasury Short Selling Consultation Paper

The Australian Treasury released a consultation paper titled "Short Selling Regime" on Friday 6 March. The paper calls for comments no later than 3 April 2009.

The Treasury paper follows the enactment of the Corporations Amendment (Short Selling) Act 2008 in December 2008 and presumably will assist in the drafting of regulations supporting the Act. Given the objective of the new legislation is to "enhance market confidence and integrity by providing greater transparency to both investors and regulatory bodies about short selling activity on Australian financial markets" its success will be dominated by the successful drafting of the regulations. So this is definitely a paper that is worth commenting on!

The paper refers to the improvement in confidence that might be generated by the short selling information and the reduced potential for rumour and speculation surrounding the activities of short sellers. The reporting should answer once and for all whether short selling really is a tool for market manipulators or not.

The paper makes the distinction between two methods of reporting of short sales; transactional (currently known as gross short sales and represented by the interim disclosure requirements imposed by ASIC) and positional (net short sales).

Positional reporting is more accurate than transactional reporting because it also takes into account transactions that close-out short positions. This is a very important difference. There is a high likelihood that transactional reporting can be misleading, making it unsuitable for reporting.

Treasury note that the Reserve Bank of Australia are pursuing additional disclosure of stock lending information as a complement to other short selling information, even though it is widely accepted that security lending data is a poor proxy for short selling. The risk here is that a second partial source of short selling data is added that also has a high likelihood of being misleading.

Layering ad hoc and partial measures of short selling is the worst of all worlds particularly, as will likely be discovered once sufficient information is collected, short selling is not so influential an impact on share prices as regulators and commentators believe. If we follow this course we will have constructed a costly and misleading infrastructure of reporting mechanisms that add little to market integrity. Transactional reporting should be dismantled once a superior method is in place, and the new RBA security lending reporting should not be pursued so that the focus can be on delivering the best possible solution.

While there will be difficulties in implementing a positional reporting regime, such difficulties are not sufficient reason to rely on poor and misleading proxies instead. Treasury refer to two such potential issues - implementing threshold reporting and dealing with investors in other jurisdictions.

Threshold reporting means excluding investors with only small short positions from the obligation to report. While in theory this would appear to be a sensible and practical initiative, and has been adopted in the UK, in practice it has serious shortcomings:
  • It will not be as accurate as collecting total data and therefore risk being misleading as is the case for transactional and security lending reporting; and
  • It is likely to be easier for investors to report total positions than to extract positions above a threshold, without significant system development
Positional reporting puts the onus on investors or their agents to provide short selling data. While in theory offshore investors may not be able to be easily compelled to provide information, they will operate with sub-custodians in the Australian market that may be able to be compelled to do so.

There is some discussion of the timing and frequency of reported data.
  • On timing, fairness (and thus market efficiency) dictates that only aggregate security data is released, and is released with a lag so as not to encourage front running strategies (akin to encouraging trading on rumour) or discourage short selling activities.
  • Cost is a major factor in determining frequency, although unless short sale positions are expected to be highly variable, frequent reporting would not be justified. (Note there is an expectation among regulators and commentators that short sale positions are highly variable. This is not borne out by experience overseas and should not be assumed without evidence in developing the Australian reporting regime.)
Discussion to date on short sale reporting, including this consultation paper, has generally assumed that short selling is a dominant influence on share price movements. Thus, greater transparency of reporting is warranted. However, this is not supported by any evidence. Consideration of the cost of implementing enhanced disclosure should also include the possibility that the additional information resulting from the short selling regime will not improve market effectiveness, because short selling has been dramatically overstated as a source of share price movements. (Note: while short selling as been under the spotlight for its potential to disrupt markets in fact it has been the ban on short sales itself that has been associated with reduced market confidence, reduced market liquidity and reduced market integrity.)

Nevertheless, there will be enhanced short sale reporting as this is what is dictated by the new legislation. The first benefit will be that if not already removed, the current ban on financials will finally be lifted. Then, if positional reporting is adopted, there will be the benefit that it will be clear for all to see what impact, if any, short selling might be having on a security price, rather than unfounded accusations that short sellers are the root cause of share price declines.

In summary, we should work towards a single best method for reporting sales that is consistent with global practice (and dismantle current partial misleading reporting) that enables aggregate short sale positions to be reported periodically with a lag. For the record I expect this data to show that the impact of short selling on share price movements, and thus the need for this additional reporting, has been dramatically overstated.

In answer to the issues for comment in the Treasury paper;

A. Positional reporting should be used in isolation because the current transactional reporting is misleading.

B. The stock lending reporting proposed by the RBA should not be pursued because it is likely to be a misleading source of short sale information.

C. Investors or their agents should be responsible for reporting short sale information because this information is already to hand and while it will take effort to effect the resulting positional reporting will deliver best available short sale information.

D. Custodian/prime brokers carry sufficient information about client's short sale data. The majority of short sellers will have some custodian/prime broker relationship in place to effect settlements and hold securities.

E. Offshore investors will generally operate with custodians that in turn have sub-custodian arrangements in Australia to effect settlements and hold securities.

F. Market operator will carry other relevant information about securities such as market capitalisation and likely be in a position to add short sale information easier than the regulator.

G. I believe that a threshold for reporting will be more difficult to implement than full reporting and will be more accurate. The costs for full reporting could be minimised by appropriate periodic reporting.

H. Refers to number of short positions excluded if various thresholds applied. Will disadvantage large managers who will more likely have positions above the threshold.

I. Current US position is for fortnightly reporting via market operator. Adopt lag in keeping with global practice. If the lag is reduced to 1 week globally adopt 1 week otherwise retain fortnightly.

J. Banded disclosure is difficult and costly to administer and relates to the influence of individual investors. The key is influence at the aggregate security level.

K. There should be a delay to avoid front running and to respect the effort that short sellers have invested in the decision they are making on behalf of their clients. Otherwise short selling is likely to be discouraged to the detriment of market integrity.

L. The data should be disclosed on an aggregate basis. As with K. above disclosing investor positions will encourage front running, fan rumour and discourage investors from short selling on behalf of their clients to the detriment of market integrity.

M. I agree aggregate disclosure could be misleading if a threshold is applied. As stated in G above more accurate reporting will result if no threshold is applied.

N. The identity of short sellers should not be disclosed whether threshold approach is applied or not. As with K and L above such an approach will encourage from running, fan rumours and discourage the use of short selling on behalf of clients to the detriment of market integrity.

O. Transactional reporting is misleading and should be dismantled as soon as a superior method of reporting is implemented. It is not a complement to position reporting.

P. Transactional reporting is flawed from the perspective of data collection (by way of brokers who are in a position to trade and profit from the additional reporting provided) and output (increased/decreased reported short sale activity may not be associated with a net increase/decrease in short sale positions and thus is misleading).

Q. If positional reporting is made mandatory then all other misleading proxies should be removed.

R. The lag in reporting should reflect international practice. The lag should be sufficient to stem front running and fanning of rumour. Assuming data is aggregated the lag could be as short as 1 week.

S. It is difficult for individual investors to see evidence of front running from current reporting.

T. The current transactional reporting will mislead whenever material short sales are closed as these are not reported. It is also confusing to investors to see financials short sales reported when they are banned from being short sold.

U. - Z. seek responses on the cost of compliance. The two elements of cost will be system development and the cost of providing the data ongoing.

AA. The cost of compliance would be minimised if the best reporting approach was adopted and other misleading approaches dismantled or not pursued.

Friday, March 06, 2009

Reflections on the Extension on Short Selling Ban

The odd thing about the extension of the ban on short selling is that the major Australian banks have re-capitalised, won market market share and are well positioned compared to their international counterparts. Yet, financials are not protected from short selling in other developed markets.

Does the Government know something about the strength of the Australian banks that the market does not know? Unlikely. Are they worried about some financial institutions in particular and the systemic risk of a bank failure? Possibly.

Then, putting aside the fact that there is no evidence to support the effectiveness of the ban, the resulting market inefficiency can be considered a tax on investors. Rather than lay the cost of this support on investors, it would be fairer to make specific provision by providing direct capital support to the organisation(s) they believe carry systemic risk. As the ban on short selling is likely to be ineffective, this is a likely eventuality in any case.

The markets could then be left to find equilibrium, operate effectively and re-build the confidence that has been lost as a result of the short selling bans applied to date.

Thursday, March 05, 2009

ASIC Extends Short Selling Ban on Financials Again

Oh dear again. ASIC has again bowed to market rumours of potential predatory short selling, announcing today that it has extended the ban on covered short selling of financial securities until 31 May 2009.

This decision was made despite the fact that:
  • Australia stands alone among the developed markets in maintaining any ban on short selling;
  • derivative or exposure based short selling is not banned, thus allowing alternative (though potentially more expensive) avenues for selling; and
  • the share prices of financials have underperformed the broader market over the period they have been afforded special short selling protection - All Ordinaries -14.3% vs Financials -21.7% 13 November 2008 to 5 March 2009.
ASIC does acknowledge that there may be a possible loss of market efficiency or price discovery as the result of the continuation of the ban, but that this is justified given the current market circumstances. The assumption here is that the ban will actually have an impact on the share prices of the companies being protected.

The decision was based on discussions with other regulators and market participants (including those who might naively expect to benefit from a continuation of the ban), but was not accompanied by any factual evidence that might support the decision.

Lets hope that by the time this decision is reviewed again, there is some reliable data available to help ASIC make a better informed decision.

Wednesday, February 25, 2009

AIMA Hedge Fund Booklet

In conjunction with Zenith Partners, the Alternative Investment Management Association (Australia Branch) has published the Hedge Fund Booklet.

The booklet is a valuable resource for anyone with an interest in hedge funds whether an investor, adviser, regulator, the general public and even managers themselves.

Amongst other things, it covers investment strategies and return attributes and discusses the impact on broader portfolios of allocating to hedge fund strategies. There is a very useful glossary of terms.

The booklet is another important step in demystifying hedge funds and allowing investors and their advisers to make better qualified portfolio management decisions.

Thursday, January 22, 2009

Australia Extends Short Selling Ban on Financials

Oh dear. The Australian Securities and Investments Commission has extended the ban on short-selling financials to 6 March 2009.

But what were they thinking?

ASIC has described the decision as a cautious one, responding to the renewed selling in financials in London and New York that coincided with the lifting of the ban on short selling financials in the UK on 16 January 2009.

But by acting differently to other regulators globally, and in view of Australia's large weight to financials, it is a risky decision that is likely to further tarnish our reputation as a reliable financial market.

There is no evidence that such bans have been effective in achieving higher share prices, or that when not in place, have resulted in lower share prices. A relative outperformance of financials in Australia of 8 percentage points over the period since the ban on non-financials was lifted has been touted as evidence that the ban has worked. But there are many factors at work in determining share prices not just short selling. The influence of short selling on share prices is just unsubstantiated heresay based on a fear of predatory practices; we need some solid evidence.

And what is the regulator, supposedly responsible for ensuring free and fair markets, doing trying to rig higher share prices for financial stocks? At the least they are terribly conflicted. At worst they are driving out investors (who want fair prices and access to short selling as a tool to manage risk), reducing market liquidity and the attractivess of the Australian market to raise capital and contributing to the undermining of Australia as a regional financial centre.

Tuesday, January 06, 2009

Impact of Short Sales Restrictions on Share Prices

A recent paper by Ian Marsh and Norman Niemer dated 30 November 2008 titled "The Impact of Short Sales Restrictions" is a timely one given some governments and regulators, including in Australia, are still forming views on the appropriate regulatory approach.

The authors were expecting to see an increase in skewness and a decrease in kurtosis as a measure of whether the short sale prohibition had been effective.

They found that the imposition of short selling restrictions had no discernible impact on the behaviour of stock returns.

The analysis was limited by the small number of observations when the restrictions were in place. In Australia of course the bans were in place longer and remain in place for financials. This may make further analysis more useful.

The study highlights the extreme position adopted by Australian regulators. The following table taken from p22 of the paper shows that Australia was the only country among the 17 developed countries in the sample that banned covered short sales of non-financial stocks as well as financial stocks - see highlighted column.

Monday, January 05, 2009

SEC's Cox Regrets Short Selling Ban

US Securities and Exchange Commission (SEC) Chariman Christopher Cox said he regrets his handling of the financial crisis and in particular the banning of short selling financial stocks.

The SEC and the UK's Financial Services Authority (FSA) introduced a temporay ban on short selling financial stocks like Morgan Stanley and Citigroup on 19 September 2008. The ban was lifted on 9 October 2008.

The SEC's office of economic analysis is still evaluating data from the temporary ban on short-selling. Importantly, Cox conceded that preliminary findings point to several unintended market consequences and side effects caused by the ban, such as reduced market liquidity.

"While the actual effects of this temporary action will not be fully understood for many more months, if not years, knowing what we know now, I believe on balance the commission would not do it again," Cox told Reuters in a telephone interview from the SEC's Los Angeles office late on Tuesday. "The costs (of the short selling ban on financials) appear to outweigh the benefits."

The SEC imposed the temporary ban under intense pressure from the Federal Reserve and Treasury Department which insisted it was crucial to the short-term survival of these institutions, Cox said.

A few weeks after the temporary ban was lifted, global markets were again dropping precipitously, U.S. banks were begging the SEC to reinstate its short-sale ban and there was talk of shutting the markets down.

Australia faced a simliar set of circumstances to the US, except that the the Australian financial sector was in relatively stronger shape. The Australian regulator, the Austrailan Securities and Exchange Commission (ASIC), was under intense pressure from Australian banks, government agencies and the press to follow the lead of the US and UK regulators.

ASIC did respond on Friday 19 September 2008 in concert with the US and UK regulators and then, remarkably, imposed a sharper regulatory response on 21 September 2008, imposing a total ban on short selling. This temporary ban on short selling was not lifted until 13 November 2008 (over a month after the ban in the US was lifted), and the ban on financials remains, with a lift being foreshadowed (but not promised) for 27 January 2009.

How will history judge Australia's policy response? Given the deeper and more protracted bans, will the unintended consequences of these actions be even greater than Cox is indicating for the US?

Wednesday, October 29, 2008

ASIC's New Short Sale Reporting Regime

ASIC has announced that it will lift the ban on short selling of non-financial stocks from 19 November 2008 to coincide with a new reporting regime for short sales.

The new arrangements require trading participants (brokers) to report short sales by security to the ASX on a daily traded (not settled) basis. Trading participants will rely on their clients providing this information at the time of the order.

The ASX will then report this information after 9:00am each trading day. The report will show the volume of short sales executed on the previous day (except for financials which are still banned) and a ratio of short sales traded to issued capital for each security.

ASIC and ASX will use the data to assist in detecting market manipulation and other non-compliance with existing obligations.


The focus on daily information is understandable and reflects current fears about the impact of short selling in stock prices. However, in practice daily reporting is likely to be seen to be unwarranted if global experiences are any guide. In the US, short interest is reported fortnightly and changes little from fortnight to fortnight. See the short interest report on Microsoft for example which shows one year of data for Short Interest, Avg Daily Share Volume and Days To Cover.

More importantly, the data collected is unusual in that it compiles transactions. This is not how information is presented on international exchanges - global best practice - which shows short interest positions in securities. If short interest positions were collected, then they could be compared with transaction volume in the security and answer such questions as how many days of trading volume does this short interest represent and how much does this short interest represent as a percentage of issued capital. This was highlighted in my post of 14 October titled "Exposure Drfat of the Corporations Amendment (Short Selling) Bill 2008".

Investors will find the publication of short interest positions valuable in their portfolio construction and risk management. Securities with high levels of short interest are at risk of a short squeeze in the event of new positive information. Some managers will be able to implement have risk limits that prohibit further short selling when short interest reaches certain threshold levels.

Unfortunately, to use the information gathered by the ASX to produce short interest positions would be a massive (impossible) exercise. There has to be another solution.

The natural reporting solution is to require short sellers or their custodians acting as agent to provide position information to the exchange.

This information would then be then compiled by the ASX for publication. As there will be fewer parties involved as compared with the current solution because custodians will represent many short sellers, the reporting process will likely be less of a burden and will provide more useful information.

Wednesday, October 22, 2008

Alphaville has published a very good article in titled "In Defence of Hedge Funds". A brief summary of the article is shown below.

The article quotes Dick Fuld recounting the position of the US Treasury towards hedge funds,
"…kill the bad HFnds + heavily regulate the rest" that came from an email between Fuld and Lehman’s general counsel, Thomas Russo, recently made public by US Congress.

The banks were clearly successful in convincing the US Treasury that the banks were not to blame and that more liquidity and more confidence was needed, not more capital. While Paulson eventually came around to the view that the banks needed recapitalising, hedge funds are still in the target sights of regulators.

The BBC’s business editor Robert Peston is quoted as saying:

"…the (hedge fund) industry as a whole hasn’t even begun to address the central charges against it: namely, that it helped to stoke up the credit bubble by providing a market for toxic investments; and that it has brought disorder to the puncturing of that bubble, through the poisonous combination of deliberate strategies to destroy the credibility of weaker financial firms, and through massive automatic sales of assets in a falling market.


The article explains:

Firstly - on “providing a market for toxic instruments”.

It’s right to say, as Peston does, that hedge funds were often the happy buyers of the lowest tranches of mortgage backed CDO's: the mezz and equity pieces that support above them a far greater number of AAA-rated senior tranches. In fact, the “toxicity” of CDOs relates to the AAA tranches which holders thought had little or no chance of default.

Smart money stopped buying the senior pieces a long time ago. Banks still wanted to issue CDOs though and needed AAA tranche buyers and built securities to carry these risks, some of which were held on their own balance sheets and have since taken large writedowns and suffered capital impairment charges. Greedy banks were the cause of their own demise.

Secondly - on “the poisonous combination of deliberate strategies to destroy the credibility of weaker financial firms”.

The article points out that you don’t need shorting to make people panic about banking confidence. It shows how the FTSE fared after the FSA banned shorting financials (indicated below by the vertical blue line):


Volatility increased and, after an initial rally, the market simply continued on its secular trend. This was the case in Australia also, as shown in my earlier post titled "Australia's Short Selling Ban - One Day Wonder?"

Thirdly - on “massive automatic sales of assets in a falling market”.

The article makes the point that sales by hedge funds have been driven by redemptions that in turn have been adversley impacted by falling confidence. Another cause of the fall has been margin calls made by the banks themselves.

The article concludes that the investment banks are the arhitects of this crisis, not hedge funds.

Tuesday, October 14, 2008

Exposure Draft of the Corporations Amendment (Short Selling) Bill 2008

The Australian Treasury are seeking comments on their short selling exposure draft. The current legislation around short selling is complex and unclear and the absence of reporting covered short selling has heightened uncertainty about its real impact and contributed to a 30 day temporary ban being imposed on 21 September 2008.

I believe that concerns about the impact of short selling on the general level of sharemarkets is overstated, and that while there are benefits in producing clearer legislation in the area, it will do little to address the current difficulties facing the Australian and global financial systems.

I am concerned that para 14 says "The Bill will replace ASIC's interim reporting requirements for covered short sales ..." If the temporary ban on short selling remains in place until the Bill becomes an Act, then the Australian financial system will be seriously impacted in the meantime.

Notwithstanding these high level comments, the draft is well balanced and shows a good understanding of the issues. I note para 16 in particular which says that "The Government is not seeking to prohibit or discourage covered short selling activity." That's good.

The draft distinguishes between naked and covered short sales. This distinction is relevant in relation to the current interpretation of the reporting requirement for short sales. Beyond that, a short sale is a short sale and the economic impact of being naked or covered is not relevant. This is a red herring in the argument.

Para 16 uses stock lending activity to estimate an upper limit of short selling in Australian listed securities of 4%. It notes that stock lending can be used for other purposes than short selling. However, there is no discussion of the likelihood that stock lending transactions may pass through many hands (it is a deep and liquid market) before it finally reaches a short seller. I have no evidence to support this, but typically a fund manager will ask their prime broker for stock availability. The prime broker may draw the stock from their own/their client's inventory or go to the market to borrow the stock for the manager. To the extent this occurs, stock lending activity will further overestimate short selling.

Para 22 argues that the absence of transparency in short selling may adversely impact investor confidence and market integrity, increasing the cost of capital and reducing investment activity. I would argue that the absence of short selling brought about by the temporary ban will also have this impact.

Para 23 discusses objectives. The first two points are side benefits to investors, but are inappropriate as objectives for any legislation. Providing information that is hard earned by one set of participants freely to others is unfair and unbalanced. In the case of the first point, "to provide a signal that individual securities may be overvalued", assumes that short sellers are better judges of share value than other investors ie those holding the investments long. This is not necessarily the case. If it is the case, then why should legislation be introduced that makes it easier for poorer judges of value?

The discussion of gross or net reporting of short sales is not relevant. Only net short selling will have an economic impact.

The main weakness of option two (para 26) is that reporting will be made on a trade basis. This implies a significant accounting requirement to follow through the impact of the sale on existing positions and to correct for any trade failures etc. Is the position opening a new short sale, extending an existing, reducing an existing ie a purchase.

It will be more straight forward to report positions and not trades at designated points of time. This information should be published from the source of truth, which is not the trade advice received by the broker. Typically brokers do not carry a record of holdings for their clients and investors may use multiple brokers to achieve a desired position.

I believe the best source of this information is held by the investor or as is generally the case, the investor's agent, the custodian or sub-custodian. Custodian's that carry short positions on behalf of clients already capture, settle and report this data daily on a traded and settled basis. Positions will also include off-market transactions for which they act as custodian. There are fewer custodians, than either investors or brokers. This alternative was not mentioned at all in the exposure draft, but is likely to be the preferred route and impose lowest regulatory cost.

Also not mentioned is that Short Interest has been captured in other markets for some time. In the US, Short Interest is published by major exchanges fortnightly eg shows Microsoft's Short Interest history. What is the process employed in these markets? Can it be applied in Australia?

Will there be areas of activity not captured by using custodians? Offshore investors will presumably use sub-custodians. Users of direct market access systems will report trades to their custodian for setlement. Broker's principal positions? Anything else?

Para 34 discusses the problem of different trading desk activity in the same firm. Using the custodian approach, each account will be aggregated across every security. The fact that some houses will have offsetting long positions is not relevant. The fact that one group in the house has borrowed stock (or sold in advance of borrowing stock or settling) as principal or for a client is what is required to be captured, and will be captured using this approach.

Para 34 also discusses whether short sale reporting should be delayed. The concern presently is that the data should be provided frequently and quickly as it is believed to be materially important. However, international experience is that data provided fortnightly serves the market well. In fact, there is little movement from one fortnight to the next. But where there is a commercial advantage for short sellers in those markets, I believe it is sufficiently preserved with this level of periodic reporting.

In summary, the use of brokers to collect short sale trade information at the point of the trade is not the most effective way of achieving the desired outcome. Periodic position reporting by custodians, and investors that do not have custodians, is likely to provide adequate transparency of short selling in Australian securities.

Sunday, October 12, 2008

Australia's Short Selling Ban - One Day Wonder?

We are now half way through the 30 day prohibition of covered short selling in Australia. Has it been effective?

On Sunday 21 September 2008, ASIC imposed a total ban on covered short selling securities on the Australian Securities Exchange. (Naked short selling and covered short selling of financial securities were banned on 19 September 2008.) The reasons for the total short selling ban were given as:
  • short selling of stocks, particularly financial stocks, may be causing unwarranted price fluctuations.
  • necessary to maintain fair and orderly markets in these exceptional times of global crises of confidence in financial markets.
  • a circuit breaker to assist in maintaining and restoring confidence
The following table shows the impact on selected financial and materials indices and companies in the day following the ban, 22 September 2008, and the movement in index levels/prices in the period that followed.


Share Price Increase
19/9/08 – 22/9/08

Share Price Decline
22/9/08 – 10/10/08

Financials (XFJ)


















Materials (XMJ)












All Ordinaries (XAO)



Not surprisingly, the ban had the desired impact immediately after announcement, but why did it fail to provide support in the two weeks that followed?

The simple reason for this is that as short selling had little to do with the crisis enveloping the Australian sharemarket and other global sharemarkets, imposing a short selling ban was never going to provide the solution. The crisis brought about by financial companies leveraging exposure to falling asset prices continues to unfold.

Now that the short term supply/demand impact of the ban has passed, longer term factors are emerging.

For example, the most prevalent hedge fund strategy in Australia is equity long/short; whereby managers invest in Australian companies expected to outperform and offset these investments with short sales. Most equity long/short managers are net long investors. A small number of managers will seek to be market neutral. Few will carry net short positions, even in exceptional circumstances.

Banning short selling prevents equity long/short managers from effecting their strategy. As these managers abandon the strategy because they cannot manage the short side, they will be closing short sales AND and selling long positions. As these managers are generally net long, this is likely to have a depressing impact on share prices.

Those equity long/short managers holding on to their existing short sales awaiting a lift in the ban, will not be inclined to close those positions as further short sales in other securities cannot be opened to provide cover for long investments. This will have the effect of REDUCING buying in companies under sharemarket pressure, when short sellers would otherwise be buying to cover their positions, further depressing share prices.

Furthermore, the ban has increased uncertainty for many investors reducing their appetite to hold Australian shares and further depressing share prices.

In summary, while the covered short selling ban had the desired impact on the first day of trading following the ban, it appears to have been ineffective in achieving the desired aims of the ban, as we have seen:
  • heightened fluctuations (falls) in share prices
  • unfair and disorderly markets
  • reduced investor confidence

Sunday, September 21, 2008

Be Careful What You Wish For ...

Be careful what you wish for. It might kill you.

This the moral of the Aesop fable the Bee and Jupiter and is an appropriate caution to opponents of short selling. There has been a shrill chorus of opposition to short selling recently, including assigning it the blame for the recent market volatility and the plunge in credit and sharemarkets.

Following a ban on short selling by the UK's Financial Services Authority, the US Securities and Exchange Commission has ordered "In these unusual and extraordinary circumstances, we have concluded that, to prevent substantial disruption in the securities markets, temporarily prohibiting any person from effecting a short sale in the publicly traded securities of certain financial firms ..."

Now the Australian Securities and Investment Commission has banned all forms of short selling for the time being. Mr Tony D’Aloisio said ‘These measures are necessary to maintain fair and orderly markets in these exceptional times of global crises of confidence in financial markets. Because of the relatively small size and the structure of the Australian market, it is necessary to extend the prohibition to all stocks. To limit the prohibition to financial stocks, as has been done in the UK, could subject our other stocks to unwarranted attack given the unknown amount of global money which may be looking for short sell plays’.

I have sympathy with the sentiments - predatory short selling, if it is not illegal, is immoral.

However, short selling in its usual form is a key to the efficient operation of financial markets. Without it market makers (I note that the regulators give market makers relief), fund managers and other market participants would not be able to hedge risk.

The United States economy may have dropped down the international pecking order as it bears the cost of widespread global military intervention, but it still remains the centre of capital markets. It is the most efficient place to raise capital. At least until now.

The decision to ban short selling in certain securities opens the door for alternative markets to take leadership. It is in the interests of listed companies to have a deep and liquid market in their securities. It is also in the interests of investors.

While removing some participants (short sellers) may conjure (manipulate) a higher price in the short term, it will likely cause wider spreads and reduced demand for these securities in the medium term. Investors will prefer to trade securities in freer markets and this will drive companies to raise capital in those markets.

Global companies that list in the United States pay United States tax, will list in other markets and pay tax in other markets. This erosion in the US tax base will further weaken the United States' position in the world. These companies already employ a large number of staff in other countries as production has been outsourced to countries with cheaper sources of labour.

Australia had a remarkable opportunity here. Rather than join Karachi, London and the New York and respond by intervening in security pricing, we could have re-affirmed the principle of free markets.

I would expect that in response, over time, companies that value these attributes would have drifted towards an Australian listing and bring investors with them. Imagine an Australian listing for GE, Google and Exxon Mobil.

Or as Australia has done today we could follow the misguided response of the UK and US policy makers and intervene by placing limits on short selling. There is currently a short selling bill before Parliament. Lets hope this knee jerk response doesn't find itself in the black letter law.

Wishing for limits or prohibitions on short selling may appear to improve the situation in the short term, however as Aesop warns, over time it will shrink the number of participants and kill off any aspirations of Australia being a regional player in financial services.

The decision by ASIC to follow suit with a harsher response puts in jeopardy the fledgling Australian hedge fund industry. Australian funds that use short sales in Australian securities to manage risk will not able to do from Monday. Should these funds be suspended for the period of the limitation? There is a strong argument that they should be closed and monies returned to investors as the funds cannot be managed as specified in their respective product disclosure statements.

Any country that can be brave enough to stand firm in support of free and fair financial markets, while regulators in current leading markets practice their voodoo economics, will have an opportunity to develop a strong financial services industry with a global presence, bringing new jobs and prosperity.

Friday, August 29, 2008

Hedge Funds - Shooting the Messenger

Hedge funds get a raw deal in the press. Its easy for journalists to point to a few "hedge funds" losing money, and then condemn the asset class as a whole. However, noone seems to make the effort to differentiate between the "hedge fund" label - which is really a synonym for "unregulated investment products" - and various strategies, some of which are highly leveraged and volatile. And in Australia of course, hedge funds are regulated and required to meet the same standards as all managed funds, including licensing and product disclosure statements.

Perhaps investors do need to be more selective of managers and strategies; but the only type of news that is relevant to managed funds as a whole is the level of fraud; which seems no higher for so called hedge funds than with other managed funds. Picking funds which got a strategy or view wrong is always easy in hindsight, but has zero relevance. On the other hand, poor fund returns are significant and probably reflect an illiquid, choppy market.

The same problem occurs globally. Patrick Hosking and Clare Harrison wrote an article in the Times on 20 August 2008 titled "Hedge funds at a loss to cope with mood swing". They reported a list of hedge fund blow ups without reporting poor returns in other mutual funds and without highlighting any success stories. The content of the story is sown below:

"The hedge fund group that took a huge bet on Northern Rock as it was imploding last autumn has reportedly lost 85 per cent of its investors' money, amid evidence of a terrible spell this summer for many hedge funds.

SRM, the Monaco-based group that raised $3 billion from investors in September 2006, is down by 85 per cent, according to The Wall Street Journal, including a minus 77 per cent performance in the past year. Tight lock-up terms prevent investors from withdrawing their money.

SRM, which was founded by Jon Wood, the former UBS investment star, is also thought to have been burnt by disappointing investments in Countrywide Financial, the American mortgage group; Bear Stearns, the investment bank rescued by JP Morgan; and Cheniere Energy, a struggling Houston-based energy company.

The news from SRM, which bought more than 10 per cent of Northern Rock only to see it nationalised, comes as many rival hedge funds post losses after being wrongfooted by the sudden change in sentiment over energy prices, financial stocks and the dollar.

Many alternative asset managers, who pride themselves on their ability to make money regardless of market conditions, posted their worst figures for years in July and most are nursing losses for the year to date.

Paragon Global Opportunities Fund, which is run Polar Capital, the London-based hedge funds group, was down 12.41 per cent in July to $897.2million.

The United States-based Pequot Global Fund is believed to have been badly hit, with one expert claiming that the fund suffered a “significant double-digit” percentage loss in July, which Pequot refused to comment on.

Another big loser is Ospraie Management, which is 20 per cent owned by Lehman Brothers. Reports suggest that it has had $1billion, or 20 per cent, knocked off the value of its Ospraie Fund this year.

For months hedge funds made money positioning themselves for energy prices and mining stocks to rise and financials to fall. But that trend reversed in July. Similarly, the US dollar regained investor popularity two weeks ago, badly burning anyone positioned for it to remain weak.

John Godden, a hedge fund consultant with IGS Group, said: “Commodity trading funds, which had a storming year till June, have been hit by the falls in energy prices. They make money on trends and when trends unwind, they lose money.”

Christopher Fawcett, the head of Fauchier Partners, a London-based hedge funds investment group, said: “There was a tendency for funds that did well in June to do badly in July.” Nevertheless, Absolute Return Trust, Fauchier's listed vehicle, was up 1.8 per cent year to date at the end of July.

Hedge fund returns sank by 2.82 per cent in July, according to the HFR's index of hedge fund returns, leaving year-to-date returns at minus 3.83 per cent, a poor performance by the standard of recent years. So far in August, returns are down by 1.59 per cent.

Mr Godden said that other hedge funds were doing well, with merger arbitrage funds and dedicated short sellers “making out like bandits”."

If you think hedge funds have disappointed of late take a look at this list of legendary money managers returns published by, a web site devoted to the principles of 'value investing'.

12 Months
Name The Average Gain* (%)
Seth Klarman -26.7
Third Avenue M'ment -23.2
Bill Ackman -18.6
Martin Whitman -18.0
Ian Cumming -17.9
Richard Aster Jr -17.9
George Soros -16.0
Robert Rodriguez -15.7
Joel Greenblatt -15.1
Tweedy Browne -14.4
David Winters -13.0
Glenn Greenberg -12.8
David Einhorn -12.5
Wallace Weitz -12.5
Richard Pzena -10.8
John Keeley -9.0
Steve Mandel -8.6
Jean-Marie Eveillard -8.3
Michael Price -8.0
T Boone Pickens -7.5
Robert Olstein -7.2
Ron Baron -7.1
Bruce Berkowitz -6.9
Ruane Cunniff -6.8
Ronald Muhlenkamp -6.7
Chuck Akre -6.5
Warren Buffett -6.2
Ken Heebner -5.7
David Swensen -5.2
David Dreman -5.1
David Williams -4.8
Hotchkis & Wiley
Robert Bruce -3.6
Edward Owens -3.5
Dodge & Cox -3.4
Bill Nygren -2.8
Richard Snow -2.8
Mason Hawkins -2.7
Chris Davis -2.4
Bruce Sherman -2.4
John Rogers -1.5
Carl Icahn -1.3
Tom Gayner -1.1
Brian Rogers -0.9
NWQ Managers -0.8
Charles Brandes -0.7
Arnold Van Den Berg 0.0
David Tepper 0.0
Edward Lampert 0.2
Arnold Schneider 4.7
Mark Hillman 6.4
Irving Kahn 13.2
Sarah Ketterer 13.6
Mohnish Pabrai 16.3
Bill Miller 29.3

Wednesday, August 06, 2008

Short Selling a Danger to Free Markets?

In the Australian Financial Review's letters to the Editor on 4 August 2008, Rohan McJannet asks the rhetorical question “Aren’t these products (short selling) dangerous to a free market?”

The answer Rohan is unequivocally no. The recent fall in sharemarkets has prompted many similar calls. Short sellers are only the messenger.

Short selling is a fundamental element of a properly functioning market. It is used by a wide range of market participants and is critical to efficient operation and risk management in our capital markets. To be efficient a market has to incorporate all information, bad as well as good.

In the case of fund managers, short sellers will borrow securities in companies they believe are overvalued, which in turn they then sell, with a view to buying back later at a profit. There is no free ride to short sellers; if a security price rises, then the short seller is faced with a loss. If they are wrong, they suffer every bit as much (possibly more) than long buyers. But in the process stocks perceived to be “overvalued” are bought and those perceived to be “undervalued” are sold, supporting the very foundations of a free market.

I would argue that the suggestion to somehow place limits on short selling while allowing activities that support the market is “dangerous to a free market”. It would quickly spell an end to Australia’s ambitions to be a regional financial centre, by reducing the ability to raise capital, lowering liquidity and reducing the ability to properly manage risk.

Of course, retail investors will likely have benefited from short selling during the past year, if they had been invested in managed funds that had the ability and skills to short sell.

Wednesday, June 11, 2008

Cayman Islands Monetary Authority Reports Aggregate Hedge Fund Data

The Cayman Islands Monetary Authority (CIMA) has released its first report using data gathered by CIMA's new electronic reporting system. The Investment Statistics Digest reviews Cayman Islands-regulated funds for the financial year 2006. It contains aggregate statistics for over 5,000 funds including their financial position, structure, investment strategies, subscription activity, fund administration and investment management services.

Australia investment managers are grouped in the Asian region alongside managers from Bahrain, Mauritius, Israel, India, Indonesia, China, Japan, Singapore, Malaysia, Kuwait, Saudi Arabia, UAE, Thailand and New Zealand.

Report Highlights

1. The aggregate net asset value of the Cayman funds captured was US$1.387 trillion.

2. New York had the largest concentration of net assets held by investment managers with US$388 billion or 28%.

3. The UK, predominantly London, had the second largest concentration of net assets managed with a total of US$250 billion, or 18%.

4. Sixty-one percent of the funds reporting had a minimum subscription of US$500,000 or more.

5. The Cayman Islands was the primary location for the provision of administration services to the funds.

6. Multi-strategy (29%) and Long/short equity (27%) were the top two investment strategies of the reporting funds.

7. A master-feeder structure was used by 50% of the funds.

8. Total subscriptions and redemptions were US$760 billion and US$483 billion respectively.

9. The proportion of funds suspending trading was extremely low at 0.1%.

For an industry often regarded as secretive, this information from the regulator of the dominant offshore hedge fund domicile is very important. CIMA plan to release annual updates.

Wednesday, June 04, 2008

AIMA's Survey of Superannuation Funds

AIMA has published an update to its 2004 survey of superannuation funds. The results are posted to its website. Click here to review. In summary while the survey published in 2006 (see my earlier post titled "Australian Superannuation Funds use of Hedge Funds") had indicated that superannuation funds were planning to lift their weight to hedge funds in coming years, in fact in the event 2008 weights were little changed from the weights in 2004.

Given that generally capacity is not a limiting factor the likely reason is likely to be simply the time it takes to implement change or the difficulty coming to terms with (understanding) the opportunities available.

One notable change was the introduction in some respondents of dedicated staff of up to 5 people whose job it is to monitor and evaluate alternatives. This suggests that the forecast increase in weight (from around 2.5% to 3.5% on average) will likely occur over coming years, although the new target is lower than when the last survey was taken.

In terms of quantum, 20% of 200 funds invited to respond did respond. These funds were biased to large funds and represented approx $100 billion of superannuation savings. An increase of 1% would thus add about $1billion to hedge fund investments.

More than 30% of responding funds had allocations in excess of 5%. Reflecting the nature of the respondents, these investments were primarily global and invested with large institutional fund of fund providers. The allocation to Australia was only 10.6% and to boutiques (single or multi strategy) was very small (5.6%). Fund of funds are expected to lose market share compared with single/multi strategy funds in coming years, but not markedly.

Funds regard operational experience, team breadth and business experience most highly (expertise), ahead of transparency and governance and certainly ahead of the brand value of the firm.

Most interest was expressed in long/short equity, distressed and emerging market strategies.

While advisers have the most influence in the hedge fund allocation decision, the survey didn't cast any new light on the role they play.

Saturday, March 29, 2008

Short Sellers - Black Knights or White Knights?

If you read Ian Verrender's article in the SMH Weekend Edition March 29-30 titled "Opes collapse could reveal a sordid tale of short selling super" you could be forgiven for thinking short sellers represent the force of evil, the black knights in the tale. It makes a good headline, but does it make sense?

There has been a decline in sharemarkets globally over the past six months and Australia has been part of that decline. Share prices can rise and fall for lots of reasons, but the key factor in this recent decline has been tighter global credit conditions following a long period of easy credit, both availability and rate.

Yes, the returns from investing in sharemarkets have clearly declined, but to point the finger at short selling is to shoot the messenger. A more believable explanation is that investing in shares above their fair valuation, and in particular borrowing by way of margin lending to invest further in such shares, is the root cause of the problem.

In fact, the presence of a deep and liquid stock borrowing market that supports short selling helps to ensure that an even greater bubble is not created, after which even harsher declines follow, as stocks inevitably retreat to reality. So rather than being the black knights, short sellers are the white knights that provide liquidity and help drive share prices to their equilibrium levels.

Investors and superannuation funds don't always have to depend on sharemarkets to rise and/or to leverage their investments to extract investment returns. They too can benefit from short selling by investing with managers that are trained to take advantage of these opportunities. Managed funds that invest in sharemarkets and adopt a market neutral strategy (see wikipedia's definition of equity market neutral) will typically invest in a diversified portfolio of companies they regard as being prospective and offset the risk of these investments by selling a portfolio of companies they regard as having poor prospects. In this way, good investment managers are able to deliver returns based on their stock picking ability without depending on the sharemarket rising.

The investment industry terminology for returns of this nature is "uncorrelated alpha". If sharemarkets continue to struggle in coming weeks and months, we might hear this term a lot more.

Friday, February 22, 2008

Assistant Treasurer Chris Bowen Blows Winds of Change

Australia's Assistant Treasurer Chris Bowen spoke to a large audience at an IFSA lunch today. The key to his speech was a desire by the government to remove any impediments to Australia becoming a financial services hub - to create a level playing field. This is a very encouraging development for the Australian financial services industry.

Financial services represents just 3% of Australia's exports. Twenty years from now he sees no reason why financial services cannot generate more export income than the resources sector. But impediments will need to be removed and the Government to step out of the way.

In particular, he foreshadowed a review of Div6C of the Tax Act by The Board of Taxation chaired by Dick Warburton. The review will look for revenue neutral changes and is required to be complete by mid-2009. In the meantime, the Government will consider interim changes. A consultation paper will be released and comments sought over the next 3 weeks. Australia's IFSA will be making a submission.

No mention was made about any changes to superannuation. This will await the budget on 9 May 2008.

ASIC Concerned About Collusion

The Australian Financial Review reported today that ASIC is concerned that hedge funds might be colluding to drive down share prices to profit from short selling. The concern appears to be around knowledge of potential margin calls.

In particular, there appears to be a concern that share price falls can be exaggerated if it results in margin calls that in turn results in further sales of stock. How much stock is called will depend on the fall in price and the extent of cover held by investors with investments on a margin basis. While share prices are evident to the market, the latter is not. There appears room to increase transparency in this area. I am not aware of any markets in the world where the extent of margin lending against a company is published. However, a good start would be to require that the margin loans and changes of margin loans of related parties in the company be made public along with declaration of holding.

ASIC Chairman Tony D'Aloisio acknowledged the important role that hedge funds play in providing liquidity to markets, however the author of the article Matthew Drummond shows his distrust of short selling by using the term "punting" when explaining the use of short selling by hedge funds and refers to this as "the ability of hedge funds to manipulate the market in this way".

By implication, investing is good and short selling is bad. This is nonsense of course. The real strength of hedge funds is that they are able to invest in companies they consider have good prospects and sell companies they believe have poor prospects thus helping to drive share prices towards fair value.

Yes collusion, if it occurs, is bad and transparency of information is good. But lets not colour short selling with an "evil" tag. That's a mistake.