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Warnings over “quick changes” to rules as short selling faces closer scrutiny

Short selling is falling under closer regulatory scrutiny following recent turmoil – but industry observers are highlighting its “valuable” role in market efficiency amid heightened volatility and performance dispersion.

Jim Neumann, partner and CIO at Sussex Partners, said short selling continues to provide liquidity, price level discovery, exercise of shareholder rights, and profit and hedging for a variety of market participants.

He cautioned against “quick changes” to rules on the practice amid periods of stress.

“While the ethics of short-selling arises without fail during market downturns, it should be considered a valuable segment of market activity,” Neumann said. “The whole concept of the benefit of being able to create alpha, long or short, rests upon being able to sell shares short to express a view, arbitrage, or hedge.”

Long/short equity strategies – often regarded as a barometer of the broader hedge fund industry given the number L/S funds in operation and volume of allocated capital – largely weathered initial market volatility during the early part of March, thanks partly to “efficient” short positions, Lyxor Asset Management said on Wednesday.

Lyxor noted that negative beta for the most directional managers was mitigated by strong alpha, driven chiefly by favourable sector and factor exposure.

The best performing long/short equity funds remained up some 10 per cent mid-month, while the worst performers gave back between 30-40 per cent.

From mid-March though, performance deteriorated as funds were struck by a mix of short-to-medium term momentum exposure, crowdedness, and rapid deleveraging which contributed to volatility.

The UK’s Financial Conduct Authority earlier this week moved to rule out a ban on shorting, as the practice – a core element of most typical hedge fund strategies – came under closer scrutiny.

The  FCA said markets have been operating “in an orderly fashion” in the UK despite continued volatility, adding there is “no evidence” that short selling was responsible for recent stock market losses.

In Europe, some local regulators have placed curbs on shorting to stem selling pressure.

“Regulators need to be careful when making quick changes to the rules during a market stress period,” Neumann said. “It diminishes liquidity, provides extra confusion, and changes markets’ ability to be the arbiter of value.”

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