Illustration: Michael Mucci.

To many it may seem implausible, even dead-wrong, that super funds lend their stock – the shares they own on our behalf that is – to hedge funds so those hedge funds can promptly “short” it, selling stock they don’t even own to drive down the share price for a quick profit.

For those not au fait with short-selling, or “shorting”, it is pretty much the opposite of buying shares, waiting for them to go up and selling them for a profit.

With shorting, you sell the shares then buy them back for a profit when the share price falls.

Short covering pumped up the price of Fortescue Metals shares this week. Photo: Louie Douvis

In order to “short” a stock, however, you first have to borrow it from somebody.

That’s where the super funds come in; they take a fee for lending their stock to short-sellers.

It is not an unreasonable question therefore, to ask if it is wrong for super funds to lend their shares so smart-alec hedge funds can make a buck by sabotaging the share price.

Indeed, it is a question quite often put by readers to this correspondent. It’s usually married with another question: “When are you going to do an exposé on that?”

“Arrium has been under sustained attack by short-sellers,” wrote one reader last week. “The nature of the attack has been relentless; from $1.60 to a recent close of $0.017. The attack seemed to be unrelated to the reality of Arrium’s operations. To a retail shareholder it seemed like someone was trying to destroy Arrium.

“There is now no need to close out a short position as the shorter and the lender can be owned by the same third party and the shorting process can be simply taking money out of the left pocket and putting it into the right pocket.”

The reader makes some valid points.

Arrium executives this week asked 400 miners to take a temporary pay cut of 10 per cent until the company could afford to pay them full salaries again.

Things are dire.

And the very thought that some Porsche-driving hedge fund types in a city office tower have been cleaning up by shorting Arrium shares while hard-toiling Aussie miners are forced into penury, well, it’s an enticing narrative.

But things are not quite so clear cut.

In this writer’s view, shorting can be destructive.

It can often transfer wealth – via a recapitalisation – from super fund owners to a coven of hedge fund malaperts.

Nevertheless, it can also be useful though in ironing out market inefficiencies.

As our Arrium correspondent noted, if shorting Arrium were illegal, it would eliminate the ability for market vultures to force such a strategically vital defence resource into the hands of receivers, or bankers hunting for a recapitalisation gig.

“Any recapitalisation of the Arrium business will redistribute ownership, from the former shareholders to those who take up the shortfall of any share issue.”

This happens a lot.

In the case of Santos for instance, the shorts attacked the share price last year, it fell, the company announced a jumbo rights issue and the hedge funds picked up stock on the cheap.

The question which needs to be asked however is, would the share price of a besieged company have fallen anyway, the shorts merely getting it there more quickly?

If the stock recovers , what have the long term holders in super funds lost?

It is often the case that a stock price will shoot higher than it ought to because the shorts are forced to “cover”, as was the case with Fortescue this week.

As a pure iron ore play, Fortescue has long been a darling for the shorters.

The iron ore price has been dropping like a stone and Fortescue has too much debt.

When the iron ore price popped 18 per cent on Monday,short-sellers scrambled to cover, or buy back stock (because they didn’t own it, having only borrowed it).

The stock swung sharply higher.

Arguably then, the bounce allowed Fortescue holders to sell at higher prices than would otherwise have been available to them.

Law firm Slater & Gordon is another darling of the shorts.

Hedge funds went to town selling it down from $7.85 to $3. Ultimately though, the stock fell – as had Santos and Fortescue – because it was too high and was poor value.

For Slater & Gordon, it was the fundamentals, not hedge fund manipulation, pushed its stock down.

If the short-sellers are wrong, they often pay dearly, as other players in the market know they have to cover and are bound to chase the stock price higher.

Their nightmare scenario is a takeover bid.

Without shorting, share prices would be artificially high for longer periods of time, exacerbating the wealth destruction that occurs when they finally blew up.

Shorting therefore is vital for market efficiency.

What is not efficient is the stock lending fee, or, if you like, the price of the rent.

At 12 basis points, the fee equates to just $120 on $1 million worth of stock.

So the hedge fund makes a motza.

Shorting Slater & Gordon, for argument’s sake, the prime broker does well, taking commission for buying, selling and teeing up the collateral. The poor old super fund pockets a lean $120.

Not all funds lend their stock.

Perpetual, for example, doesn’t. Those who do though are arguably being diddled on the commission.