Short-selling hedge funds in the firing line again as stock markets crash

Critics claim London market provides too liberal an environment for short traders
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As stock markets continue to tumble, the search for someone to blame intensifies. Currently in the firing line are short sellers, who sell shares they do not own in the hope of buying it back more cheaply later on. Typically hedge funds, short sellers are blamed for driving prices down and increasing market volatility. They are the market's bad boys of the moment.

As stock markets continue to tumble, the search for someone to blame intensifies. Currently in the firing line are short sellers, who sell shares they do not own in the hope of buying it back more cheaply later on. Typically hedge funds, short sellers are blamed for driving prices down and increasing market volatility. They are the market's bad boys of the moment.

David Prosser, chief executive of Legal & General, has started a campaign against short selling, saying it disadvantages long-term savers. He is also proposing a tax on the practice as a means of discouraging it.

Yesterday saw David Varney, chairman of the mobile phone network operator mmO2, wade into the debate. Lambasting the "woeful adequacy" of the disclosure rules relating to short selling, he urged more stringent regulatory procedures. "Many in the markets and industry believe aggressive short selling is damaging interests of long-term investors," he said.

Mr Varney said that in the eight months since mmO2's demerger from BT, more than 1.6 times its shares in issue had been traded in London. This was despite little change in its shareholder register. "The obvious implication is that the shares have been lent to hedge funds and other institutional traders to enable them to trade," he said.

But are short sellers really responsible for the precipitous fall in share prices? Or are they more a symptom than a cause? And is there a hidden business agenda behind some of the stances taken on this controversial issue? For example, Legal & General stopped stock lending after the 11 September tragedy as a means of trying to starve hedge funds of the shares they need to sell short. But rivals, such as Barclays Global Investors, continue to offer the service as it generates fees. In theory, this would enable Barclays Global's huge Aquilla tracker fund to undercut L&G's trackers with lower fees.

In 1990 the total capital under management of hedge funds was less than $20bn (£13bn), says Hedge Fund Research in Chicago. Earlier this year the amount had mushroomed to $600bn. The growth has been fuelled by the greater fees that can be generated from hedge fund management. Falling markets have also increased the attractions as hedge funds can sell short as well as "go long" (ie buy shares with a view to them rising over the long term. Conversely most traditional pension funds operate long-only positions and cannot sell short).

The criticisms of hedge funds are legion. They are accused of poor disclosure, limited regulation, favourable tax treatment from registering their operations offshore and exacerbating downward movements in shares. The collapse of Long Term Capital Management in the US in 1998, which sparked a global financial crisis, gave hedge funds an image problem that has been hard to shake off.

The conflicts of interest are huge. If an institution lends stock to a hedge fund, it is likely to receive back a parcel of shares worth less than before. How is that in the best interests of pension fund investors?

And the bulge-bracket investment banks are currently doing vast trades with hedge funds (often more than 50 per cent of their business). How does that service square with the services they are providing to traditional pension fund clients? Another criticism is that hedge funds benefit the "super rich" against the interests of ordinary savers. This is because most hedge funds that are aimed at private clients have a minimum £100,000 investment limit.

The Financial Services Authority has conducted an initial investigation into the issue of short selling but said it sees no case to answer, so far. "We have done some initial analysis which does not suggest an increase in short selling," the FSA said yesterday. "We do not see short selling as a problem but we are continuing to monitor it."

Hedge fund managers say they have been unfairly made the whipping boys of the bear market. Crispin Odey runs Odey Asset Management, which has $1bn of funds with 40 per cent of that in hedge funds. He says it is ludicrous to blame the market's woes on people such as him. "The reason the market is going down is not because hedge funds are shorting the market. It is because the life insurers are being forced to sell equities and buy bonds," Mr Odey said. "None of us [hedge funds] have naked bear positions. They are all hedged against long positions and they need to be because some of the rallies in a bear market can be so sharp. You can't make a lot of money out of being short as you can only make 100 per cent [if a share price falls to zero]. Going long you can make a multiple of your investment [if a share price soars]."

Stanley Fink, chief executive of Man Group, the UK-listed hedge fund manager, feels hedge funds cannot have had such a powerful influence on the market for one simple reason. "The global hedge fund industry is relatively small. It manages about £400bn, which is less than 2 per cent of liquid assets under management," he said.

What are the potential remedies? One is for more disclosure. Crest, the settlement house of the London stock market, compiles stock lending figures and could publish the data on a weekly or monthly basis so investors are aware of stocks where there could be short positions. "It should be more transparent because we do not have a level-playing field at the moment," one senior fund manager said.

A second is for more regulation. Many hedge funds are registered offshore even though the traders might be in London. Bringing them into the regulatory loop would help dispel the mystique that has grown up around them. As John Hatherly, head of research at M&G says: "They have grown up overnight and there probably isn't enough regulation. Something bad could happen and investors may not be adequately protected."

A third is for short-term market gains to be taxed. However, hedge funds say this would damage one of the key benefits of short selling, which is to increase liquidity.

A fourth approach would be to adopt US-style rules. There the market has an "uptick rule" where a share can only be shorted if the last price movement was in an upward direction.

However, market experts suggest that over regulation cannot prop up weakening sentiment. As Edward Bonham Carter, chief executive of Jupiter International, says: "Japan has tried to restrain it and the market has continued to fall. I believe the fundamentals will out. Good companies go up, bad ones go down. Hedge funds just exacerbate the movements."

Shorting relies on stock lending to work

Stock lending is a common practice used in a wide-range of market situations, not just short selling. However, it can be used in controversial ways such as the attack by Laxey Partners on British Land last week. The rebel shareholder acquired a 9 per cent shareholding in the company as a launch pad to table a series of resolutions to shake up the company. It later emerged that most of the stock had been borrowed enabling Laxey to vote a far larger proportion of the company's equity than it actually owned.

Institutions will sometimes lend stock directly. Or they will lend to intermediaries, which include major banks and small, specialist boutiques. The lender will not necessarily know the ultimate recipient of the shares.

It will charge a fee for the service. This will typically be a fraction of a percentage point of the return on the investment. This depends on the risk but is usually around 10 to 15 basis points.

The lender will take collateral for the loan, in cash or other shares. The loan will be over days, weeks, months, or even years. However the lender will reserve the right to call back its stock at any time.

Why do they do it? The simple reason is to make money. Stock lending offers a valuable revenue stream, particularly to tracker funds which cannot engage in active fund management.

It can backfire, of course. An institution could lend stock only to find it is worth less than before because the borrower has been a hedge fund which has tried to drive the price down.

But institutions argue that this outcome is far from certain and that it is this difference in view between the "buyer" and "seller" which helps make a market.