Hedge Funds Not Alone in Defending Short-Selling Secrecy

The debate over short selling often pits traditional “long-only” managers against the upstart alternatives: hedge funds. But as this report in yesterday's FT points out, the lines between “traditional” and “alternative” are blurring quickly. The Alternative Investment Management Association (AIMA) has been an ardent defender of the hedge fund industry against what it sees as unfair criticisms in the media (see related posts).

But now associations of “traditional” investment managers have come to the defense of short-selling. In fact, according to the FT, the Investment Company Institute (ICI) in the US, the Investment Management Association of the UK (IMA), and Australia’s Investment and Financial Services Association (IFSA) have each warned regulators against requiring short-sellers to publicly reveal their short positions.

The head of the IFSA tells the FT:

The clients of fund managers and mutual funds pay the fund manger for their services and they don’t pay for their services so others can have access to what they are doing…

Why would organizations of non-hedge funds advocate for something that seems to benefit only hedge funds? Apparently because many of their members believe shorting is a good idea. The fact is that short-selling is simply a strategy. Hedge funds, it is often said, are a legal structure - not a strategy. The FT seems to suggest that a hedge fund strategy such as, for example, a long/short strategy, is not necessarily synonymous with a hedge fund at all

In November, Thomas Donaldson, a professor of legal studies and ethics at Wharton gave a talk on “hedge fund ethics” during which he argued that hedge fund regulation was beset with several fundamental problems. Chief among them was what he called “regulatory recalcitrance” - the fact that hedge fund regulations were often at odds with the very rationale for hedge funds. According to the website “Knowledge @Wharton” Donaldson said:

I want to suggest that there is something to the idea that smart people can create novel strategies, and that this is something to be protected. This is a social good…I do not want to prevent capitalistic acts between consenting adults.

According to the account of his talk, Donaldson is certainly no fan of hedge funds. Yet he, like the (traditional) fund associations listed above, see value in some form of less-than-full transparency.

In his Congressional testimony on hedge funds’ role in the financial crisis, Houman Shadab of George Mason University made the following important distinction:

Given the complexity of the issues involved in this inquiry, it is helpful to make the following distinctions to clarify the difference between financial institutions, instruments and activities.

• Financial institutions include banks, investment funds, insurance companies, and
  broker-dealers.

• Financial instruments include securities such as bonds and collateralized debt
  obligations derivatives such as options and credit default swaps.

• Financial activities like using leverage and short-selling.

Using Shadab’s rubric, short-selling is an activity that is performed by many different institutions (hedge funds, long only funds, pension funds, insurance companies) and using many different instruments. In that sense, it’s no surprise that hedge funds aren’t the only ones coming to the defence of short selling.

Comments

[Valley Outs...:]

The main reason as I see it for the huge downturn in the market over the fall of 2008 was hedge funds putting large amounts of sell calls into the marketplace, and shorts on ETFs bringing down individual stocks like the last car on a rollercoaster. For an individual investor, this amounts to trying to ride your bike along a highway and stay on the road while 18-wheelers fly past you. You don't stand a chance. The supply shocks from these two forces were big enough and there were enough of them to push the price down in a major way and there was nothing you could do about it.

Now the question is, what market forces exist in large enough quantities to push the prices back to where they were?

Another question is, why am I riding my bike on the freeway? Why invest where you have so little clout or control of the environment? I don't personally have anything against hedge funds as an instrument, but I will continue to look for genuine bike paths to ride on from this point on.

Jan 08 05:36 PM

[joe1:]

Hey... wasnt Uncle Bernard Madoff "shrouded in secrecy" to??

Jan 08 05:37 PM

[vatexas645:]

Short-selling is not the problem in and of itself as a strategy. The problem is the use of short-selling as a strategy to manipulate share prices for profit - In My Opinion. And I believe it happens regularly and such manipulation should be prohibited. How can it (manipulation) be prohibited if there is no transparency?

Jan 08 07:52 PM

[Phil Trupp:]

There is a great deal of illusion and phony mysticism at all levels of finance, especially in the world of hedge funds. Hang around long enough and you'll discover there are no secret trading strategies, no secret pathways to profit. In truth, common sense, familiarity with market dynamics, repetition, and luck make the wheels go round. And let's not discount the rule we know only too well: crime pays the highest dividends on Wall Street.

Hedge funds are opaque because they don't want to lose the hype--mystique which lures wealthy investors into the fold, allowing them to believe they are sainted members of a super-exclusive society. This was the Madoff formula--and it worked. Hedge funds are in fact fairly mundane operations. They do well in bull markets (most of us do) and not so well in bear markets (like the rest of us). If hedge funds work financial magic, how do we explain the collapse of so many pricey funds in 2008? Where were the geniuses--the magicians when the Dow shed close to 4000 points? With few exceptions last year, most hedges shorted their clients into ugly losses then refused to open "the gates" when calls for redemption reached panic levels. Their exhuberant shorting foolishly sucked trillions of dollars of value out of the markets while their disenchanted investors scurried to the sidelines.

George Soros once remarked that the secret of making money in the stock market is to find an idea that is bound to fail and bet against it. Good advice. You don't need to pay 2 and 20 to understand such wisdom. But as long as there are fools with too money hedge funds will find a way to first romance and then fleece them.

Jan 09 12:28 PM

[ROLEX18K:]

am sorry to ask, maybe it's not polite, but who of all the SA experts ever bought a Rolex or Mercedes from trading stocks,futures,options they are experts on.
I propose to SA to make "REALITY CHECK METER" photo album where we can see a super trader wearing Patek or even Omega or sitting in his Bentley or at lest BMW 3.
I make about 10,000-15,000 $ a month trading on my own and have no boss but when I read SA experts I feel like I am kinf of freak or homeless

Jan 09 01:09 PM

[ain't no fo...:]

Legal short selling where shares are borrowed and delivered by settlement date is not the issue. It is in fact a legitimate and time honored way of adding liquidity to the markets while allowing an individual to make a bet that goes contrary to conventional long (and often wrong) thinking on a stock.

It is the illegal NAKED shorting that is the virtually exclusive domain of the hedge funds who use it to pile into a short position WITHOUT borrowing/holding shares as collateral, and who DON'T deliver said stock by settlement date). They use these gangbang tactics to short companies into oblivion and have imperiled the markets because they have long CDS positions that only payoff if the company they hold them in goes bankrupt.

This naked shorting has nothing in common with legal shorting except the name, and it is egregious and despicable.

And I wish people would understand the difference before they assail ALL short selling without knowing the first thing about what they're talking about.

Jan 09 02:09 PM