In life, naysayers and pessimists rarely win popularity contests. Much the same could be said about short sellers, the professional party poopers of the investing world. Short sellers are hardly strangers to criticism. However, the intensity of the opposition to short sellers and short selling has reached a fever pitch of late.
Short sellers suffered their latest blow on the morning of Dec. 10, with the announcement that the United States Department of Justice (DOJ) has opened a far-reaching investigation of short-side hedge funds.
Digging for dirt on short sellers
The DOJ probe appears to have a sweeping mandate, targeting a wide range of market participants, including several of the best known short-side hedge funds and research organizations currently in business, as Bloomberg reported on Dec. 10:
“Authorities are prying into financial relationships between hedge funds and researchers, and hunting for signs that money managers sought to engineer startling stock drops or engaged in other abuses, such as insider trading, said two of the people, asking not to be named because the inquiries are confidential...The U.S. probe opens yet another front in an already treacherous era for those who try to profit on stock drops. Some bearish funds threw in the towel as government stimulus buoyed prices during the pandemic. That pressure intensified as retail investors organized counterattacks on popular short targets, bidding up shares to inflict losses on hedge funds this year. Underscoring the inquiry’s sweep, federal investigators are examining trading in at least several dozen stocks.”
The investigation has reportedly begun to dig into the activities of a number of influential players on the short side in the U.S. market, including Muddy Waters Research and Citron Research, as well as foreign-based hedge funds like Anson Funds Management LP. Companies that have been targeted by short sellers are also being investigated, including Luckin Coffee Inc. (LKNCY, Financial) and Gaotu Techedu Inc. (MEX:GSX, Financial).
Short sellers under fire
Even before the DOJ probe was announced, short sellers were facing heavy fire. In fact, short sellers, and the practice of short selling in general, have been vilified by critics ever since the practice came into existence with the birth of modern public capital markets. However, the vitriol directed at short sellers has intensified in recent years, with numerous market influencers even going so far as to call for an outright ban on short selling, a subject I have discussed at length previously.
Moreover, short sellers have been struggling to survive in the latest manic phase of the long bull market. Many of the most heavily shorted stocks have been the targets of coordinated short squeezes that caused catastrophic losses for a number of hedge funds with big short bets, such as Melvin Capital. Rather remarkably, many of the year’s most painful short squeezes have come about as the result, not of sophisticated attacks by professional investors or asset managers, but of coordinated mass action by large groups of retail investors. Such was the case with GameStop Corp. (GME, Financial), for example, which has enjoyed an historic bull run fueled by a monumental short squeeze courtesy of retail investors.
Under such conditions, it is hardly surprising that short sellers are none too thrilled about a DOJ probe being added to the mix. Already embattled and facing attacks from all sides, they hardly needed a new front opened up against them.
Unpopular but necessary
While some have cheered the news of the DOJ probe, I fear it could end up doing far more harm than good for the integrity of capital markets. Short sellers play a vital, if unpopular, role in the investing ecosystem. They dig for the facts that companies might prefer to go unnoticed and question the narratives that underpin lofty valuations. In short (pardon the pun), they do the work that most investors have neither the time nor the inclination to do themselves. Yet it is important work nonetheless.
While I can empathize with those investors whose stock positions have suffered after coming into the crosshairs of short sellers, the simple fact is that, if short sellers’ criticism is legitimate and factual, then they can hardly be said to have done something wrong. Short sellers may put a dent in a stock you like, but I would argue that that is ultimately a small price to pay in order to ensure that public companies are honest with their shareholders.
Should the DOJ’s investigation diminish short sellers’ willingness or ability to perform these tasks, all investors will be poorer for it, by my assessment.
Trade carefully!
Disclosures: No positions.
