The long and short of short-selling

Trustees will be watching carefully the effects of the recent ban on short-selling imposed by the City regulator.

Markas Gilmartin
Markas Gilmartin

It is claimed that short-selling - when traders bet on share prices falling - is aggravating the current market instability. Short-selling is a legitimate investment technique in normal conditions. Investors borrow an asset, such as shares, currencies or oil contracts, from another investor and then sell that asset in the relevant market hoping the price will fall.

The aim is to buy back the asset at a lower price and return it to its owner, pocketing the difference. Anyone can short a share position, but hedge funds are typically the main players. Such capital instruments can provide liquidity to the markets and increase the efficiency of portfolio management.

Although short-selling of bank shares is not responsible for the recent fall of financial stock values - for example, only 3.5 per cent of HBOS stock was on loan when it fell 40 per cent - it may have created stock market uncertainty.

The Financial Services Authority announced a new provision to the Code of Market Conduct to prohibit the active creation or increase of net short positions in specific publicly quoted financial companies. The list comprises 33 companies, including household names such as Prudential, Barclays and Schroders.

The FSA required daily disclosure of net short positions above 0.25 per cent of the ordinary share capital of a company held at market close on the previous working day (although investors now have to notify the FSA only if the position has changed).

Regulators in Ireland and the US followed suit. This helped, but it may have limited the flexibility of certain funds - particularly those with an absolute return mandate, such as hedge funds.

If trustees have invested in hedge funds, this raises an immediate question: should the portfolios be liquidated? In answering the question, it is worth bearing in mind that 'shorting' provides liquidity to capital markets and is an efficient portfolio management tool. Consequently, the FSA has indicated that these new rules will remain in force only until 16 January. In the meantime, they affect only financials, and no doubt a host of different methods will emerge to create gains in falling and flat markets.

Trustees may have to review their cash needs, risk appetite and asset allocation policies. But if they are investing for the longer term, using portfolios diversified by asset class, region and management philosophy, with the financially strongest managers, the best policy seems to be to sit tight while the legislative changes take effect.

- Markas Gilmartin is an adviser director at AWD Advanced Wealth Management

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