Balancing the market through active long/short investing

However, the objections against short selling seem to be emotionally rather than rationally founded. We have not yet seen strong indications or arguments that support the assumed causal relationship between short selling and stock market sell-offs, rather the contrary. For this reason, in most countries, including the U.K., Germany and here in the Netherlands, regulators generally don’t resort to short selling bans.

In this article we are not going to make the case for passive short investing in stocks. Simply because we can’t, neither from a performance angle nor from a responsible investing angle. Neither can we make the case for passive long investing in stocks. What we can and will do is advocate active long/short investing in stocks. Which requires active trading as well as engagement.

Let’s start with some basic market functioning. The mere fact that an investor (passively) holds a long position in a stock doesn’t make its price rise. Investing would be very easy if it did. Similarly, a stock doesn’t decline because participants are holding short positions. Prices only decline when sellers sell more aggressively than buyers are buying. A stock market collapse requires very aggressive selling. But it doesn’t make any difference whether these sellers sell out of long positions or into shorts.

Aren’t there moral differences between long and short investing in stocks? There certainly seem to be. But again, most of these differences are more emotionally than rationally founded. For instance, holders of stocks in a company may embrace the idea that by buying stocks they help fund the particular company. (This idea is also often used as an argument to not buy stocks in companies that one does not want to support.) However, this is only the case if they buy newly issued stocks, for instance in an IPO. In regular stock trading, capital is just being transferred from one investor to another. The company concerned doesn’t receive a single cent of this capital. Similarly, short sellers don’t take capital away from the companies whose stocks they sell.

Having said this, a higher stock price could make it easier for a company to attract new capital. But as we said before, the rising and falling of stock prices is determined by the acts of buying and selling, not by the direction of the positions of (passive) market participants. Passive investors therefore hold a financial interest in the companies they invest in, but the well-being of these companies is not affected by the investors passively holding a position in their stocks. It doesn’t make a difference whether these positions are long or short.

Engagement

Active investors, on the other hand, can improve the well-being of a company through active engagement. For instance by offering constructive advice or other support to a company’s management. Not only in shareholder meetings, but also more directly in face-to-face discussions. Investors can also promote the products or services of the companies they invest in, or otherwise promote the reputation of these companies. As long as they are transparent about their investments in these companies, this can be considered sound practice.

In this respect, short investing surely is different. How morally correct would it be if an investor would advise a company badly or would campaign against a company in order to profit from a short position in its stock? Definitely unethical is the intentional spreading of false information in an attempt to profit from the resulting impact on the stock price. But here again there is no difference between long and short investors. In most jurisdictions, it is forbidden to manipulate markets, up as well as down.

When considering the appropriate kind of engagement, not only the direction of the position in a stock is relevant, but also the intended investment horizon. We believe that the long-term well-being of a company is best served if shareholders with a longer-term commitment to the company set the tone. Not investors with a shorter-term investment horizon, such as ourselves. This principle forms the basis of our modest position regarding engagement towards listed companies in which we (indirectly) invest. We have consciously chosen not to be an activist investor who, through (public) engagement, tries to influence corporate strategy and thereby the share price. As shorter-term investors we strive to benefit from large price movements, either up or down, but we never want to be the cause of such movements.

Our role in the market is different: to bear shorter-term market price risk, to offer liquidity, and to contribute to price discovery. Not only in stock markets, but also in fixed income markets, currencies and commodities. This does not mean that we refrain from active engagement. It just implies that our engagement is not aimed at listed companies, but rather at exchanges and regulators. We regularly discuss observed issues regarding market functioning with relevant parties. We also try to engage with the broader investment community on these issues through articles on our website and in magazines, as well as through participation in events and panel discussions.

Trading activity

Bearing market risk, offering liquidity and contributing to price discovery are interconnected roles. And they all require trading activity.

Although strictly speaking investors also bear risk by simply holding a passive position in a stock, such risk taking is comparable to crossing the street without looking. A well-functioning stock market requires active risk takers. The relationship between price and risk is a balancing act: a higher price leads to a higher risk, while a higher risk should translate into a lower price. Active investors have to make that happen.

When more and more investors underestimate the risk – or passively close their eyes for it – a stock price will rise above its fair value. Some find it immoral to profit from declining stocks. But is it okay to profit from a long position in a stock when its price rises above its fair value? Isn’t such profit solely dependent on other investors paying too high a price? Not selling an overpriced stock will not prevent the stock from eventually falling. It will typically only delay the decline until it ultimately crashes even harder. Bubbles are blown before they burst.

Losing money from time to time is an inherent part of bearing risk. It’s the offer an investor must be prepared to make in order to earn a risk premium in the longer run. Responsible investors are aware of this. They do not take risks that they are not willing or able to bear. And when they suffer a loss, they don’t look for scapegoats, but regard that loss as a possible outcome of a decision they consciously made. In this respect there again is no difference between long and short investors.

The fact that offering liquidity also requires trading activity will be more obvious. However, the relationship between trading activity and liquidity is not as straightforward as often assumed. Liquidity is regularly used as a synonym for turnover. Exchanges like to present high turnover numbers (trading volumes) to demonstrate solid liquidity. From that point of view, a high volume flash crash would be a manifestation of tremendous liquidity, while the opposite is actually the case. A market is liquid when a sizable order can be executed without significant market impact. At least without driving the market away from its fair value, either above or below it. Here, offering liquidity and contributing to price discovery interconnect.

In reality, not all orders sent to a market offer liquidity. Pure liquidity takers transmit orders to be executed at any price, such as market orders or stop orders, or orders resulting from VWAP or TWAP-type execution strategies. Pure liquidity takers also tend to allow little time for the execution of their orders, even when their strategies are longer-term strategies. And they don’t connect the timing of their execution to opportunities or disturbances in the market. Liquidity suppliers, on the other hand, typically use limit orders. They are only willing to buy below a certain price and/or willing to sell above a certain price. They don’t mind if an order doesn’t get executed, or at least have the patience and opportunity to wait for a better moment.

As we stated above, a stock market collapse results only from aggressive selling. Such selling is typically done by liquidity takers. To halt such a collapse, liquidity-offering buyers are required. Essentially, it doesn’t matter whether such buyers are buying into a long position or out of a short. However, one can imagine that in the heat of a stock market collapse, parties with a short position will have a greater propensity to buy than those looking to build up a long position. Because the latter would have to assume a risk, whereas the former can reduce risk (and take a profit). That’s why during stock market sell-offs, short sellers typically reduce their positions. And it’s an important reason why many regulators don’t resort to short selling bans.

Parties that are short in an imploding market and parties that are long in an exploding market provide, if they are prepared to reduce their position, liquidity for all those parties who wish to sell or buy in these respective situations. This is precisely the position that we seek to achieve, often with success. It is by no means exceptional for us to sell during extreme price rises in order to reduce existing long positions and to buy during extreme price declines in order to reduce existing shorts. We are best able to act this way when we start with a balanced portfolio consisting of both long and short positions, not only in stock markets, but also in fixed income markets, currencies and commodities. And the more balanced our portfolio, the better we can help balance the market.