Part 3: Shorting can be a valuable price discovery mechanism if done right.

Hedge Fund used to have a precise meaning. Limited Partners (LPs) invested in Hedge Funds who were bearish in order to “hedge” the rest of their portfolio which was long ie bullish. Hedge Funds then later came to simply mean a bunch of very smart people getting paid a lot of fees by LPs to make them a lot of money.

Short selling Hedge Funds can provide a useful service. One example of a useful service provided by a short selling hedge fund is when Jim Chanos (Founder & President of Kynikos, which is Greek for “cynic“) shorted Enron, because he spotted evidence of fraud before others did. Chanos does not always get it right and now talks about his painful short in Tesla. Shorting Enron was a good example of “sticking it to the man”, so he should be popular on Reddit investing forums.

Short selling can be good for price discovery. A short seller such as Jim Chanos spotting fraud at Enron is clearly adding a lot of value. Two other markets illustrate why short selling can be good for price discovery:

  • Crypto markets in the 2017 bull run.  Before you could go short Bitcoin or other crypto using derivative exchanges such as CME, prices went up super fast and then crashed hard. Now that shorting is a more  normal part of crypto, prices are a bit more stable.
  • Private Equity during the valuation inversion between public and private markets (ie when private shares were valued higher than public shares), a subject Daily Fintech first covered in 2016 in Square & the public private valuation inversion for VC backed Unicorns. The reason for the inversion is simple – you cannot short private shares. Now that inversion is over and valuations of many tech stocks resemble the Dot Com era is not a good time to stop short selling. 

Destroying good companies via collusion is obviously not good. Sadly this is all too common as it is an easy way for short finds to make money. Nor is jumping into over shorted companies just because everybody else is shorting that stock adding any value. After the GameStop saga, both types of short sellers will be a lot more careful.

See previous post in this 4-parter.

See first post in this 4-parter.

In next week’s concluding post we peer into our crystal ball to estimate what changes can we expect in future?

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