STAYING THE COURSE: Shorting and Leverage in the face of new market dynamics

Long ago, an energy company called Enron was, owing to the investigative work of a soft-spoken Fortune reporter, revealed to be not only an unregulated trading organization built on a complex maze of debt and fraud, but an actively destructive enterprise aligned against national infrastructure, able to manipulate the power grids of certain US states through disruptions and blackouts.

For many years leading up to these revelations, Enron had been widely touted as a pillar of a new economy, at the absolute forefront of innovation, where people regarded themselves as revolutionaries.

Early red flags in public reports were uncovered, and acted on, by a handful of short sellers and the scandal would wipe out vast shareholder wealth as the share price raced to zero and the company declared bankruptcy. As was pointed out repeatedly in the aftermath, the wealth destruction would have been far worse if not for short sellers pushing back against the inexorable rise before the fall. And Enron’s executive leaders predictably blamed the attack of short sellers for the failure of the company during their criminal trials.

It’s an old story that has played out again and again over time: traders trust in the bedrock certainty that short selling makes markets more efficient, analysts appreciate the importance of having early indicators of corporate distress, while distraught CEOs wail in self-righteous fury at the short sellers of their companies’ stock, even though the short activity is quite often temporary and fleeting.

Recently though, as the volatility of certain share prices skyrocketed due to social media hype and mob-like retail trading frenzies, a common refrain emerged from the professionals, lamenting the inability of short sellers to do their important work. After all, even though the retail investors dabbling in short selling will most likely get burned and lose their tolerance for it, who can afford to maintain short positions in view of absurd price swings like those seen in Game Stop in early 2021?

Likewise, recently reported hedge fund collapses causing substantial losses within certain banks’ prime brokerage units would seem to indicate extraordinary levels of margin leverage being extended by those banks.

Yet, taking a closer look at hedge funds’ actual average short exposures and leverage levels, it appears that perhaps the more things change, the more they stay the same.

Hedge Funds' weighted average Short Market Value as a percentage of Gross Market value, compared to Vanguard Total World Stock Index and Gamestop stock price. Source: Hazeltree

Hedge Funds' Gross Market Value as a percentage of Equity, Mean and Median. Source: Hazeltree

Hedge funds on average maintained their typical profile of long-to-short exposure, even throughout the disruptive Gamestop, AMC and Nokia cycles.

Hedge Funds' Long, Short, Gross Exposure, as a percentage of Equity compared to Vanguard Total World Stock Index. Source: Hazeltree

So, the professional traders can apparently withstand extreme volatility while deploying leverage and still perform their important social function of maintaining efficient markets. And corporate titans can endure cycles of distressing levels of short interest in their shares, while deploring the wicked short sellers, and still build successful businesses. And individual investors, armed with easy to use trading apps can play too, but they should remember some important old adages: borrowing on margin is risky, and short selling is not for the faint of heart.