A client has recently asked me if I could “explain what short selling is and how hedge funds use them. I have heard they are highly risky and I also know of concerns that exist about some of their ethical standards.”
Unlike the simple buying of shares where an investor buys them hoping that they will rise, short selling is a tactic used to make money when a share price goes down. If the price does fall the person who has shorted them gains and vice versa.
So is there a problem? Well, many hedge funds operate at an ethical value I am sure. Personally I don’t use anything unless it is fully transparent. If I can’t see why an investment will go up or down I don’t make the investment. If I make a decision that later turns out to be wrong, I want to be able to still say that I would still have made that decision at the time I invested. I don’t want to be kicking myself because I believed noise and because I made an investment without knowing the details back to front.
Unlike the investment in shares, shorting is much less regulated. An investor investing in a share wants it to go up and everyone investing in such shares will want it to go up. This is good for the economy and the strongest shares do well but shorting is a negative approach which has a negative outcome.
It is easy to see why the Alliance for investment transparency (AIT) exists in the U.S. This coalition of publicly traded companies promotes transparency in the market place. Hedge funds are wall street’s largest customers controlling over $ 1.5 trillion in assets. (1) The AIT is firmly of the view that despite attempts by the securities and exchange commission to initiate regulation of these funds, that the market remains highly vulnerable to illegal market manipulation schemes.
Their view has been offered to the Senate that such schemes involve collusion between hedge funds and so called ‘independent stock analysts’ providing research on a stock. (1) They believe they create that data and send it out into the market which in turn drives it down or up, depending on what the need of the investor is. It’s what I often refer to in this column as noise.
If you think about it, it makes sense. If you have enough clout and the ear of enough of the media, you talk a share up and then short it, easy money. Alternatively you could also talk it down then buy it.
There is also the ability to buy a contract for difference which effectively means investors have to put much less down to participate. Like spread betting, investors are investing on margin (i.e. to have an investment of $ 1000 you might only have to put down $ 90 for example). If you think about this carefully, a gain will be multiplied upwards by this margin and a loss would be multiplied downwards. And so to make a decision where you believe the market will definitely go your way means you have to be pretty sure. How might you be pretty sure? It’s therefore easy to see why the AIT is driving for this opacity to be dealt with.
A former investigator for the U.S. Securities and Exchange Commission gave a testimony to the U.S senate judiciary committee
“The potential harm that hedge funds can inflict on other market participants has no real limits. Hedge fund trading now dominates the nation’s capital markets.” (1)
Whilst most hedge funds I am sure are perfectly fine, my reasons for not using hedge funds relates to the opacity. In twenty years of advising investors I have analyzed countless predictions on where the market or a stock will rise to. Invariably the prediction is complete twaddle. So if they do not know if a market or share can rise, how can they predict if it will fall and in any event, get paid any.
Resource (1) AIT
About Peter McGahan and Worldwide Financial Planning:
Peter McGahan is the Managing Director of Worldwide Financial Planning – FT Award winning Independent Financial Advisers. Peter writes for many national and local press publications and is widely repected as an expert in personal finance. Worldwide Financial Planning specialise in the provision of expert one-to-one advice in the areas of Mortgage, Business Finance, Investment, Pension and Retirement Planning and Inheritance Tax. Peter McGahan is an Independent Financial Adviser and the Managing Director of Worldwide Financial Planning Ltd who are authorized and regulated by the Financial Services Authority. ‘The FSA does not regulate Credit Cards, Will Writing and some forms of mortgage and Inheritance Tax Planning.’ Information given is for general guidance only, and specific advice should be taken before acting on any suggestions made. The above represents the personal opinions of Peter McGahan. All information is based on our understanding of current tax practices, which are subject to change. The value of shares and investments can go down as well as up.