It’s not easy to be a stock market villain


It’s not easy being a short seller. The odds are stacked against you from the start. Stocks tend to go up over time, so unlike peers who buy stocks before selling them, you don’t get the ride of a rising market. Then you have to navigate a tricky risk-management dynamic: when you’re right, your stocks go down, but that decreases position size and therefore your potential return; when you are wrong, your position grows, increasing your risk. As a short seller, the maximum you can earn on a stock is 100%, but there is no cap on potential losses.

If that’s not enough, there’s a stigma attached to taking the other side in a world where most people cheer on rising prices. In his recently published memoir, John Mack, former CEO of Morgan Stanley, is clear about who he sees as the villains of the global financial crisis: “These short sellers were destroying a legendary franchise, built over nearly three-quarters of a century hard work and integrity.

Research firm Hindenburg Research found itself subject to a similar waiver after it published a barrage of criticism of Indian group Adani and disclosed a short position in securities related to the group. In response, Adani called the company “the Madoffs of Manhattan” and argued that the report amounted to “a calculated attack on India”.

Given the challenges, it’s no wonder high profile short sellers gave up. In 2021, Bill Ackman announced his retirement from activist short selling. This was after losing $1 billion on Herbalife Nutrition Ltd., which nonetheless underperformed the index. “The moral of the story: short selling is not a good way to make money,” he wrote last week. “But it makes for good documentaries.”

Yet the role that short sellers play in maintaining efficient capital markets is important. They increase liquidity because for every short seller there is a party on the other side of the trade ready to pay the given price. And, most importantly, they help detect fraud.

This last function is particularly relevant. In a recent article, researchers from the Universities of Toronto, California and Chicago estimate that “on average, 11% of large publicly traded companies commit securities fraud each year”. The authors estimate that normally only a third of corporate fraud is detected; in total, such deception destroys 1.7% of equity value per year, equivalent to $744 billion in 2020.

While regulators, auditors, and research analysts have a responsibility to fight cheating, they often lack the right incentives. Statutory auditors are paid directly by the companies they oversee; regulators lack the resources available in the private sector; and research analysts don’t necessarily see this as their job. “It’s the job of analysts to sell ideas,” one of them told a German parliamentary inquiry into the Wirecard AG scandal. “Wirecard was one of my strongest recommendations.”

With a profit incentive, short sellers are uniquely placed. Unlike whistleblowers, who can earn a share of the penalties the Securities and Exchange Commission imposes in cases of proven fraud, short sellers are outsiders and rely on public information. Armed with enough curiosity and tenacity, they can be paid well to dig where others won’t.

But it is a labor-intensive activity. Given the weight of the interests of the other party, the burden of proof is high. An anonymous report that brought to light fraud at Chinese coffeehouse chain Luckin Coffee Inc. in early 2020 involved over 1,500 people counting customers at the company’s 4,000 stores and recording over 11,000 hours of video , according to the Wall Street Journal. Hindenburg’s 100-page report on Adani was the culmination of a two-year investigation

In his response, Adani said many of the points Hindenburg raised are “already in the public domain” – as they should be, given inside information rules. Adani also points to Hindenburg’s profit motive as a conflict of interest: “Hindenburg did not publish this report for altruistic reasons, but only for selfish motives.” Of course, there’s also an incentive to fuel the market with misinformation, and given the stock’s slump since the report’s release, Hindenburg has still made money. But if it is to be in business for the long term, the company also has an incentive to protect its reputation.

Aligning incentives is difficult, but the role that activist short sellers play in keeping markets fair has many benefits that should not be ignored. There will always be cheerleaders for rising prices, creating a market for overly optimistic projections and false numbers. It is important to have a counterweight, even if it can be decried.

More from Bloomberg Opinion:

• Adani Saga questions investor confidence in India: Andy Mukherjee

• Adani Hindenburg’s short seller opened a Pandora’s box: Shuli Ren

• Let’s hope Bill Ackman doesn’t soften too much: Chris Hughes

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Marc Rubinstein is a former hedge fund manager. He is the author of the weekly financial newsletter Net Interest.

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