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.
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The flip side of using index funds to obtain beta cheaply must be widespread use of short-selling. The efficiency of index funds depends upon active management to convey price signals to the market. As the weight of indexing grows the impact of long-only managers on price levels is attenuated. Short selling simply makes the price discovery process more efficient for everyone involved. Taken to its logical conclusion there should be only two types of funds in the market - index funds which cheaply take advantage of market efficiency to obtain beta; and market neutral funds who offset their increased research and management costs with a stream of pure alpha (and as a by-product make markets efficient so index funds can deliver).
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