Hedge funds fight back against accusations of stock short-selling

The Financial Times
By Elizabeth Rigby

November 29, 2003 ... David Prosser, chief executive of Legal & General, took a lot of flak last year when he complained that short-sellers were distorting the market and called on the Financial Services Authority to put "more grit in the system".

But this week's revelation that short-sellers have sold more shares in Aim-listed Room Service than exist, creating settlement problems and leaving many small investors out of pocket, suggests that the outspoken Mr Prosser had a point.

Short-selling involves traders selling a stock they do not own - they borrow them from long-term holders such as insurers - in anticipation of buying it back more cheaply at a later date and pocketing the difference.

Although market-makers are active users of this technique, hedge funds also trade in this way. And it has been the hedge funds, which have grown rapidly in recent years and so account for a greater share of market trading, that have found themselves the focus of considerable criticism as a result of their shorting practices.

But the FSA, having mulled over Mr Prosser's criticisms, concluded that shorting improves market efficiency. Now it is going to have to revisit the issue in light of the Room Service scandal.

"We have not changed our general view," it said yesterday. "But we will reflect on the issues that this case has raised in terms of large short positions."

Normally when a market-maker or hedge fund takes a short position, it will borrow the stock and then return it at a later date.

But in the case of Room Service, market-makers - one of which is believed to be Evolution Beeson Gregory - were putting on naked positions. This means they were shorting the shares without entering arrangements to borrow the underlying stock from long-term shareholders.

They did this because they thought more Room Service shares were coming on to the market through a planned rights issue.

When the rights issue fell through, the short-sellers were unable to settle their trades. The shares have since been suspended.

Nigel Smith, a shareholder who is co-ordinator of the Room Service Shareholders' Action Group, says he is angry at the slow response from the FSA and London Stock Exchange to the short-selling. "For most investors, aggressive shorting is unethical. The regulators dropped the ball on this occasion. They failed to prevent the market-makers from exploiting investors, many of whom wish to rescue this company and give it a new lease of life."

But is this case indicative of what normally happens when market-makers - particularly hedge funds - short stocks?

One hedge fund manager yesterday pointed out that it was not shorting the stock that was the problem, rather that the market-makers did not cover their positions.

"This is not about shorting per se. It is about lack of enforcement on the part of the London Stock Exchange on forcing the market-maker to deliver the stock. It also means that the market price is the wrong price. The market-makers were shorting the stock knowing full well they could not deliver it back. That was depressing the price unfairly."

Hedge funds are big short-sellers. A long/short hedge fund manager will buy and hold some stocks while shorting others.

In asset terms, hedge funds manage $600bn (357bn) in worldwide equity markets worth an estimated $30,000bn.

But as active traders, their influence is far greater than the sum of their parts, says Stanley Fink, chief executive of Man Group, the listed hedge fund manager.

"If you say that hedge funds' assets make up about 2 to 3 per cent of the markets, their volume trading in certain stocks will go to 15 to 20 per cent, so they do have a wider influence because they can be geared and they trade a lot."

Mark Brown, global head of research at ABN Amro, thinks hedge funds could be even more active than that.

While hard figures are not available, he reckons these investment vehicles are responsible for at least 30 per cent of market volumes. "They have become important because markets have struggled and absolute returns have become difficult to come by. In that environment you need to look for as many investment opportunities as possible. Hedge funds have twice as many options because they can short. That is a valuable tool in difficult markets."

While the case of Room Service shows what can happen if a market-maker does not properly hedge its shorts, shorting is no bad thing, says Tony Dye, the contrarian investment manager who now runs his own long/short hedge fund. "It's all just special pleading on the part of companies. They say the stock has gone down because of hedge funds but it has actually gone down because people don't want to buy it at the price it is. Prosser does not whinge when the market is going up."

The FSA has sought to improve transparency in the market by getting Crest, the UK securities settlement system, to publish monthly data on lending stock from the FTSE 350 as a very rough proxy for short-selling.

In July, 27.2bn worth of stock was on loan.

Through Crest, the shorting game has become a little easier to understand. Speculators like to capitalise on market-moving events, such as potential merger activity and capital raising.

Recent targets include Wm Morrison Supermarkets, which is mulling a revised bid for Safeway.

Crestco estimated that between 20 to 24 per cent of the stock was on loan at the beginning of October, against 10 per cent a month earlier.

There was also a flurry of stock lending over Royal & Sun Alliance's deeply discounted rights issues.

RSA, which announced a one-for-one issue at the price of 70p a share in September, saw its stock plunge in the following weeks amid aggressive short-selling.

At one point, the price dipped to 80p, having been as high as 154p before the announcement. Through September, 15.42 per cent of the stock was out on loan, according to Crest.

RSA says up to 140m - or 10 per cent of its total share account - was being traded on some days.

"It was an active time, because, when it comes to a rights issue, some people will be happy with it and others won't take up their rights," says Malcolm Gilbert, of RSA. "Because of this, there was a lot of shimmying about in the run-up. But everyone got where they wanted to be in the end of the process, with take-up of virtually 100 per cent."

He adds: "Are hedge funds ganging up? It is impossible to tell. But, in essence, what they are doing is not wrong. They are just speculating. You hear stories about hedge funds acting in concert, throwing money at the same stock. But it is all unsubstantiated."

But hedge funds do little to dispel the myth that they are vultures in the markets. The whole sector is shrouded in secrecy.

Hedge funds are largely offshore and unregulated. Their managers - who if UK-based are regulated by the FSA - do not disclose performance figures and other fund information.

Most will not talk to the press. Nor do they like their names in the papers.

"The industry sometimes does not do itself any favours," argues Chris Mansi, a senior investment consultant at Watson Wyatt. "I would argue that some hedge funds like the fact that it is a secretive world, and so when there are misguided articles there is not a concerted fightback because there isn't necessarily the motivation to correct some of these perceptions."

But, for once, it is not the hedge funds under the spotlight for their trading techniques but market-makers.

"We don't think hedge funds were behind this," says Mr Smith. "Aim stocks are just too small for them. It is not hedge funds bending the rules this time round."

[ RGM Short Selling Home page ]