Short selling: An investment strategy with an image problem

Short sellers are a peculiar species among the many actors on financial markets. Their actions require not just a lot of capital, loads of detective work, and plenty of staying power, but also necessitate good risk management practices and a dose of courage. Short sellers are beloved by few, but they perform an important control and corrective function on markets. Over the course of the ongoing bull market in recent years, more and more hedge funds have pulled out of this tough business. Individual private investors should bet neither along with nor against short sellers. However, possessing knowledge about this investment strategy with an image problem can be helpful.

Detested and expendable(?)

Betting on falling share prices and thus (seemingly) on the failure of companies goes against the natural instincts of stock-market investors, but that’s exactly the line of work that short sellers engage in. Their business goes like this: (1) borrow shares and sell them, (2) afterwards buy the shares back at lower prices and return them to the lender, and (3) then pocket the price difference (minus the borrowing costs) as a profit. This investment strategy has been around for centuries and has always had an image problem. Napoleon, in his day, characterized short sellers as “stock-market highwaymen” and outlawed the controversial trading practice. A few years ago, Richard Grasso, the former chairman of the New York Stock Exchange, called short sellers “despicable and un-American.” Short sellers are disliked to this day, particularly by the CEOs of companies whose shares are in their crosshairs. They also have a tough time with public policymakers. Short sellers repeatedly have been falsely stigmatized as instigators of turbulence on equity markets, and short selling has been banned temporarily at times, such as in the case of financial stocks during the 2008 financial crisis in the USA. The most recent example of this was delivered by South Korea in late 2023 in the form of a general ban on short selling in the runup to the country’s parliamentary elections. Short sellers, though, are actually downright loved by at least one group of people: journalists. Short sellers often supply spicier information than typical brokerage reports provide. Short sellers, not infrequently, are the only ones who go against herd opinion, and they sometimes uncover sensational scandals. They regularly provide rich fodder for the media.

One of the most spectacular short trades in history was the bet against Enron made by Jim Chanos, the founder of the hedge fund Kynikos Associates. In the year 2000, he was one of the first investors to detect irregularities at the US-based energy company and helped to uncover a massive accounting fraud there. The implosion of Enron’s stock price from USD 79.14 (Chanos’s average selling price) to a mere USD 0.60 per share in December 2001 likely reaped him a profit of over USD 100 million back then. But there have also been some interesting short-selling stories in more recent times. One example is the 2020 story of the purportedly electric-powered Nikola truck that was shown merely rolling downhill with no power in a marketing video. This manipulation by the Nikola Corporation and its systematic deception of the public were uncovered by Hindenburg Research. This investment research firm specialized in short selling has drawn increasing attention to itself in recent years with its successful short bets. But there have also been some big busts now and then in the past. For instance, in 2016, Bill Ackman and his hedge fund Pershing Square Capital Management started to bet against Herbalife, a maker of weight-loss shakes and vitamins. An investigation of Herbalife by the US Federal Trade Commission found that the company indeed deceived consumers, but did not fraudulently operate a pyramid scheme as Ackman suspected. In the face of losses in the triple-digit millions, Ackman eventually threw in the towel in 2018.

Shorts in general are hard | Shorts in a bull market are even harder

HFRX Equity Hedge Short Biased Index*

* HFR suspended publishing the performance of the HFRX Equity Hedge Short Biased Index effective as of August 15, 2024, due to a lack of constituents.

Sources: HFR, Kaiser Partner Privatbank

Not an easy business

As the last of the preceding examples illustrates, short selling is one thing above all: an extremely tough business. A gain of 100% at the most (in the event that the price of the stock drops to zero) is counterpoised by a potentially unlimited loss (if the price of the stock rises). A short seller needs a lot of staying power because even if there are very good reasons for betting on a falling stock price, it can take a very long time until the rest of market participants spot a company’s weaknesses and its stock price drops. A short seller also needs luck with the timing. A misfortune, for example, is when a shorted stock suddenly becomes a speculative plaything of takeover rumors, which can happen particularly in inexpensively valued markets. To get around the timing problem, (activist) short sellers usually publicly disclose the rationale for their positions. Short-selling campaigns of that kind regularly result in short-term success (in the form of at least temporary price declines in the shorted stock). However, companies in the crosshairs of short sellers are increasingly taking legal actions to defend themselves, so short sellers frequently operate with one foot in the courtroom. But the biggest problem facing the strategy aimed at earning profits on falling stock prices is – hardly surprisingly – rising stock prices. Short selling accordingly has hardly been lucrative in the bull market that has been raging for 15 years now. To wit, the performance of the HFRX Equity Hedge Short Biased Index has averaged out to –10% per annum since 2009, and that has had repercussions. Dozens of hedge funds with a short bias have had to close in recent years. The number of funds in the HFRX Equity Hedge Short Biased Index decreased to 14 this past summer from 54 in 2008, prompting index provider HFR to capitulate and suspend publication of the index. Even Jim Chanos has raised the white flag by now. In the aftermath of bad speculations (including against Tesla) and in view of the drastically diminished assets left in his hedge fund (which fell from USD 8 billion in 2008 to USD 200 million in 2023), Chanos paid his investors their capital back in the spring of 2024. However, his basic assessment of the equity market hasn’t changed. In his last letter to investors, Chanos wrote that the “golden age of fraud” is still in full swing.

(Too) many obstacles | Short sellers on the retreat

Number of short-selling campaigns worldwide

Sources: Diligent Market Intelligence, Kaiser Partner Privatbank

The GameStop rollercoaster

Short selling has always been a difficult endeavor, but it has become even more challenging in recent years. This is due in no small part to the increasing influence of social media and the growing role being played by small retail investors thanks to commission-free stock trading. An article on short selling therefore cannot do without talking about the legendary GameStop episode. In the year 2020, shares of GameStop seemed a perfect candidate for a textbook short trade. The company sold computer games and for years had neglected the trend toward online retailing and gaming. It still conducted its (chronically loss-making) business largely the old-fashioned way through approximately 5,000 bricks-and-mortar stores located mainly in the USA, Canada, and Australia. The unattractiveness of GameStop’s business model was compounded by weird statements by the company’s CEO, suspected accounting shenanigans, and the apparent lack of a strategy for the future. To many hedge funds, it was obvious that GameStop’s stock price could only go downhill in the long run. However, they didn’t reckon with bumping up against a horde of thousands of small retail investors who were sitting at home bored to death by the COVID-19 lockdown. They spotted the hedge funds’ big short positions and coordinated a classic short squeeze via the online forum Reddit at the start of 2021. Over a three-week period that began on January 4, GameStop’s stock price soared from USD 4.50 to over USD 80 at its peak. The short sellers who were caught on the wrong foot by the rocketing stock price ultimately had to close out their positions at substantially higher prices. Their short covering additionally fueled the rally, leaving casualties in its wake. Hedge fund Melvin Capital was squeezed so severely that its losses on its speculation on GameStop intermittently amounted to over 50% and necessitated cash injections from other hedge funds (Point72 and Citadel). Melvin Capital never recovered from that shock. A little less than one-and-a-half years later, the closure of the hedge fund, which was still worth billions, was announced by its founder, Gabe Plotkin.

The purported victory of David (small retail investors) over Goliath (hedge funds) has since been chronicled by Hollywood in the film “Dumb Money”. But this episode on the capital market also had other consequences for the hedge fund industry: it was followed by hearings before US Senate committees and by investigations of dozens of hedge funds and short sellers by the US Securities and Exchange Commission (SEC). The hearings and investigations have yielded no outcomes or indictments to date, but the SEC has tightened disclosure rules for short selling. As of the start of 2025, hedge funds now are required to disclose their short positions at the end of each month if they exceed a certain size (2.5% of all shares outstanding, or more than USD 10 million). The increased transparency is desirable from the perspective of the public at large precisely because the business of hedge funds is generally perceived to be very opaque, and it is all the more why short sellers are likely to steer clear of meme stocks like GameStop, AMC, and Blackberry in the future.

An explosive mixture | Small retail investors vs. hedge funds

Price performance of GameStop shares

Source: Bloomberg, Kaiser Partner Privatbank

Why we need short sellers

However, let us hope that not all short sellers will withdraw in the face of the difficult environment. It is beyond dispute that short sellers do a world of good for the financial market – the body of research on this issue is unequivocal in its findings. For one thing, short selling facilitates price discovery. Since short sellers face potentially unlimited losses, their positions are frequently backed by thorough research. Short sellers frequently spot irregularities that analysts, auditors, and investors overlook. Their sell orders exert downward pressure on the prices of overvalued stocks and contribute to establishing a fairer market price. Precisely in today’s investment world, in which passive strategies (ETFs and index funds) account for an ever larger percentage of invested capital and in which investment banks hardly issue sell recommendations anymore, active market participants like short sellers are vitally important. Moreover, short sellers improve market liquidity. A study by the Federal Reserve Bank of New York¹ showed that the partial ban on short selling imposed on the US equity market during the financial crisis did not prevent stock prices from plummeting further, but led to lower liquidity and higher trading costs, contrary to the intention of regulators. Similar findings were reached by a study² that examined the March 2020 coronavirus crash on six different stock markets in Europe. Third, the active participation of short sellers in the financial market reduces the risk of stock crashes. In a natural experiment, Deng et al.³ demonstrated that the lifting of constraints on short selling decreases the risk of drastic price crashes.

Viewed positively, short sellers act as policemen on the equity market. In a study titled “The Invisible Hand of Short Selling,”⁴ Massa et al. highlight how short selling functions as an external governance mechanism that disciplines the managers of publicly traded companies to engage in less window dressing of financial statements. According to Jonathan M. Karpoff and Xiaoxia Lou,⁵ short selling also contributes to faster detection of misleading information and deception of the public. Short sellers thus sometimes do the job that is actually entrusted to regulatory authorities. In the case of the spectacular bankruptcy of German financial services firm Wirecard, for years short sellers were on the right trail, but were driven into a corner by Germany’s Federal Financial Supervisory Authority, which even banned short selling of Wirecard shares for a time. In summer 2020, Wirecard’s executive board finally had to confess that EUR 1.9 billion really was missing from the company’s coffers, proving the short sellers right in the end.

In summary, short selling is an essential element in the financial-market architecture. Hedge funds, by the way, would not be able to hedge without short selling. However, certain (malicious) practices for which short sellers often get criticized in the media shouldn’t go unmentioned. One of them is the use of “short-and-distort” strategies, an illegal practice whereby misleading information about a company is deliberately disseminated, particularly via social media these days. A stock-price plunge induced this way often can be exploited profitably. Naked short selling is another practice banned in most jurisdictions. Naked shorting is the act of short-selling shares on the market without having borrowed them beforehand. Naked shorting not only puts greater downward pressure on the stock price of the attacked company than would normally be possible (because a sufficient number of shares is not always available to be lent and borrowed), but also increases the risk of incorrect trade settlements.

Not a strategy for individual private investors

Hours and hours of research work, finite financial resources, and limited profit possibilities coupled with the risk of potentially unlimited losses make it obvious that short selling is not a strategy for individual private investors. But it is just as inadvisable to join the other side and bet against “evil” hedge funds along with the day-trading community. However, the empirical evidence on the short-selling strategy and its side effects that has been accumulated over the last several decades isn’t all in vain. For example, it has been proven many times over that a high percentage of short-sold shares (short interest) is a good predictive indicator of a future below-average corporate stock-price performance. Another good indicator is the fees that a short seller has to pay to borrow shares of a company. A high lending fee implies keen demand from short sellers and signals a mispricing of the stock. Individual private investors can use short interest and borrowing costs as a filter for their investment decisions. This not only enables them to avoid overvalued stocks that are likely to underperform in the future, but also spares nerves. A look at the performance of the Goldman Sachs basket of most-shorted US stocks shows how volatilely they have behaved in the past. Their performance fluctuated wildly again in 2024 and oscillated between almost –10% and +15% in the space of a few weeks in early summer.

A playground for gamblers… | …but not for investors

Most-concentrated shorts basket vs. Russell 3000 index

Sources: Goldman Sachs, Bloomberg, Kaiser Partner Privatbank

Conclusion

Short selling is not something exclusively for speculators. For fund managers, for example, short selling is a vital tool for hedging a portfolio against risks. But even speculation by a classic short seller isn’t objectionable in principle. As the policemen of Wall Street, short sellers perform an important control function. It would be desirable if short sellers were allowed to keep on playing this role in the future. Their participation in price discovery can contribute to establishing a fairer value at least for shares of small-, mid-, and large-cap companies. But in the micro-caps space, where lending fees sometimes reach high double-digit or even triple-digit territory, the bar for a successful short trade is set prohibitively high for even the most daring short sellers. This market segment will likely remain a stomping ground for bored small investors in the future. Short sellers and individual private investors should both steer clear of this part of the market.

¹ R. Battalio, H. Mehran, P. Schulz (2011): “Market Declines: Is Banning Short Selling the Solution?”

² W. Bessler, M. Vendrasco (2022): “Short-selling restrictions and financial stability in Europe: Evidence from the Covid-19 crisis”

³ X. Deng, L. Gao, J-B. Kim (2020): “Short-sale constraints and stock price crash risk: Causal evidence from a natural experiment”

⁴ M. Massa, B. Zhang, H. Zhang (2014): “The Invisible Hand of Short Selling: Does Short Selling Discipline Earnings Management?”

⁵ J. M. Karpoff, X. Lou (2010): “Short Sellers and Financial Misconduct”