Wall Street’s most reviled investors worry about their fate

Some are rethinking their strategies. They are wondering whether the practice, portrayed in the 2015 Hollywood movie The Big Short still has a profitable future.

Short sellers, including hedge funds such as Plotkin’s Melvin Capital, had wagered that GameStop shares would fall while its mall-heavy business shrank further. Instead, the shares skyrocketed when a group of mostly amateur investors, coordinating via social media and determined to outsmart big Wall Street funds, went on a buying binge.

Their actions shook Melvin, whose troubles spread to at least one other fund, Point72, which had an investment in Melvin. Point72’s billionaire founder, Steven A. Cohen, who owns the New York Mets, deactivated his Twitter account after he and other Jewish money managers were targeted on social media, with some receiving personal threats and anti-Semitic hate speech.

On February 18, the short sellers will be under scrutiny at a hearing of the House Financial Services Committee, led by Representative Maxine Waters “We must deal with the hedge funds whose unethical conduct directly led to the recent market volatility and we must examine the market in general and how it has been manipulated by hedge funds and their financial partners to benefit themselves while others pay the price,” Waters said in a statement.

It’s unclear what regulators will do, if anything. During the financial crisis of 2008, the Securities and Exchange Commission temporarily barred short-selling on 1,000 financial stocks, saying that it was necessary to provide a boost to shares of banks, brokerage firms and insurers during the worst of the crisis. But studies showed that the ban did little to prop up those stocks, and the rule was scrapped.

Even before the GameStop frenzy, short selling was in a tough stretch.

Traditional short sellers see themselves as financial detectives, sniffing out corporate wrongdoing or inflated stock prices, while aiming to make a profit. Their strategy: borrow shares of the target company from a brokerage firm and immediately sell them, expecting that they will eventually fall — sometimes on account of their research, which they often share widely.

If the price falls, the short seller buys the now-cheaper shares back, returns them to the broker and pockets the difference. But the strategy can be risky. If shares climb — either because other investors make the opposite bet, as in GameStop’s case, or simply because the short seller got it wrong — short sellers lose.

In the past year, as the stock market soared more than 16 per cent, hedge funds that were mainly shorting stocks lost nearly 47 per cent, according to a Hedge Fund Research index that tracks industry performance.

“Short sellers have been beaten up and left for dead on the side of the road in this bull market,” said James S. Chanos, founder of the short-selling hedge fund Kynikos Associates, who is best known for predicting accounting fraud at Enron before it collapsed in 2001.

The depiction of short sellers as evil by hobbyist stock traders has troubled professionals such as Koppikar, a portfolio manager at Orso Partners, a San Francisco fund. “I could probably have more economic success doing something else, but I think that what we do serves a social purpose,” he said.

Short sellers have weeded out corporate wrongdoing.

Two decades ago, Chanos began poring through regulatory filings and interviewing energy-market participants about the Houston energy trader Enron, which he suspected was using accounting gimmicks to lift revenues and hide losses. His hunch, and accompanying short position, proved prescient. Within a year of his investigation, Enron filed for bankruptcy.

Short sellers also sounded alarms about the impending housing crisis driven by subprime mortgages, shorting the mortgage insurer MBIA and the investment bank Lehman Bros., whose collapse helped set in motion a financial crisis in September 2008 and led to a devastating recession.

And in the mid-2010s, as the opioid crisis was raging, a short seller exposed Insys Therapeutics, which he believed was improperly influencing doctors to prescribe a powerful nasal spray containing fentanyl that played a role in the death of at least two patients. (Multiple former Insys executives have since been sentenced to prison on federal charges that the company bribed doctors to prescribe the spray.)

Marc Cohodes, a longtime short seller who now raises chickens on a farm in California and trades his own money, sought to distinguish between short sellers who focus on rooting out questionable business practices and illicit behavior, and other hedge funds that use short-selling purely as a betting strategy.

Cohodes, perhaps best known for exposing fraud at the subprime mortgage lender NovaStar Financial and at the Belgian software maker Lernout & Hauspie, said that many of his former colleagues now find themselves “in very crowded trades in a bull and speculative market and it’s destroyed what’s left of short sellers.”

The New York Times