Long short managers have long had an image problem. Despite significant PR efforts from many of the larger firms, efforts to rebuild the reputation of the industry have largely failed. The problem comes down to the fact that, in some minds at least, the hedge fund community embodies the worst characteristics of capitalist society. On the one hand, they are opportunistic predators seeking to take advantage of others’ misfortune or, maybe more common in recent years, a bunch of overpaid under-performers.
It’s this dichotomy that was so interesting at the beginning of the Covid-19 pandemic. Faced with the greatest market shock of our lifetimes, if not in all of modern history, hedge funds had a choice; capitalise on the feeding frenzy of market turmoil and corporate failure and be labelled vultures, or fail to do so and forever be ridiculed for not taking advantage of the clearest active management opportunity in a decade.
What we’ve seen, however, has been something else – not a purely self-interested pursuit of profit or a lack of investment ideas, but a completely different role altogether: short-sellers are becoming the fact checkers of capitalism.
A clear example of this has been the Wirecard saga. Short sellers were able to expose a $2bn accounting black hole in the firm which, up until that point, had escaped the attention of both regulators and auditors. Of course, this wasn’t altruism in action – our data shows that hedge funds made €1.6bn from short positions against Wirecard in June alone (see chart) – but it also started to reframe the narrative about the role that hedge funds play in markets and society.
Shortly after the Wirecard saga, journalists rushed to congratulate the group of short sellers involved. Chris Bryant, writing for Bloomberg, said that: “Short sellers deserve our appreciation, not scorn, for helping root out corporate frauds.” Meanwhile, The Economist ran one of its leaders in June with the headline: “Wirecard’s scandal shows the benefits of short-sellers.”
For those watching from the sidelines, the Wirecard story played out rapidly in front of our eyes, but the reality is that the short sellers who profited from the situation had been positioned to do so for several years. It’s this ability to take high conviction, long-term stakes based on detailed proprietary analysis that makes short sellers an indispensable arbiter of truth in modern investing.
Wirecard – unique and high profile as it was – could be just the tip of the iceberg. The great Oracle of Omaha himself said: “you only find out who is swimming naked when the tide goes out” and the deep and prolonged economic downturn that is sure to follow the pandemic could provide rich pickings for short sellers.
This becomes even more apparent when you consider some of the trends that have developed since the last recession, for example the availability of cheap debt, growing acceptance of non-standard accounting practices and a boom in emerging markets where regulatory frameworks can be less transparent or non-existent. As hedge fund manager Jim Chanos said in a recent interview with the Financial Times, “we are in the golden age of fraud”.
This matters from an investment perspective, but it also matters for society at large. Faced with a tidal wave of fraudulent activity, it’s likely that regulators will be overwhelmed and left without the resources necessary to investigate all instances of fraudulent activity. This is where hedge funds – who have the technical skill, capital and incentive to pursue suspected cases – can step into the fold. It’s the ultimate payment by results model.
Many things will change as a result of the Covid-19 pandemic, and it looks like our perception of short-sellers could be one of them. The cold and rational approach that once defined hedge funds as callous profit-driven machines may be the perfect tonic to markets which are awash with panic, fake news and egotistical CEOs and founders. As trust erodes in the traditional structures that previously held companies to account, new ones will need to emerge. It looks like the historic bad boys of finance may be about to become the good guys.
By Peter Hillerberg, co-founder of ORTEX