Equity investment used to be such a simple idea.
You bought shares, the price went up and then you sold them for a profit. If the price went down you held on, received the dividends and told everyone you were a long-term investor.
There is, however, a Through the Looking-Glass version of this world, one where traders sell first and then buy the shares after the price has fallen. And in this Lewis Carroll world, instead of receiving dividends, when the trade goes wrong you have to pay these out. Welcome to the upside-down, inside-out world of the short seller.
It is important to say early on that this is very different from the world of ‘short ETFs’ (exchange-traded funds), which are another matter altogether. Before we venture deeper into the domain of the short seller we must solve one glaring impossibility. How does one sell shares one does not have? Given that the buyer on the other side of the trade is doubtless eager to receive their new purchase, the seller has to deliver stock on settlement day. This is where the stock lender steps in with a simple solution. The short seller borrows shares from someone else in order to hand these over to the new buyer.
Now let us deal with dividends. Imagine that you are a shareholder in Vodafone and you have loaned some of your shares to a short seller. This is only a loan after all, you will still want your dividends. But you can’t have them as the chap you gave your shares to has already flogged them on to someone else. The short seller thus has to pay you the equivalent value of the dividend to which you are entitled.
Then there is the fee. If you are loaning out your shares, then it is only reasonable you should charge for this. Imagine again that you are a unit trust, or a life fund, or a pension fund holding gargantuan amounts of every share under the firmament. Is it not common sense to try to make extra returns from charging fees to lend your shares to someone wanting to borrow them? Seems like free money.
The risk though is that the fund to which you have loaned your shares fails to pay a dividend or is unable to return your shares. Short selling can become loss making very quickly, with the short seller exposed to a rising share price, plus paying a fee and being liable for dividends.
At times ‘going short’ is more than an exercise in analysis and patience. It can easily get down and dirty. Sellers can accuse companies of anything from misfeasance to outright fraud. Companies in return can accuse the shorters of libel, slander and market manipulation.
