"Do you believe in God, Monsieur Le Chiffre?"

"I believe in a reasonable rate of return."

– James Bond, Casino Royale

During the Great Financial Crisis (GFC) of 2008, many influential figures encouraged market participants to buy stocks to "shore up the market." They claimed it was "the patriotic thing to do." I grew up in an era when patriots were altruistic individuals who put their lives at risk so that others may have a better future. Somewhere along Wall Street, a patriot became someone who put other people's money at risk in order to guarantee an end-of-year bonus and ego massage.

In the GFC, short sellers did not decimate anyone's pension for a simple reason: pension funds did not allocate to short sellers. Neither did they cause the GFC. Short sellers did not securitize toxic debt or cause the real estate market bubble, nor were they responsible for its collapse. Their crime was to do their homework, take the other side, and profit from the debacle.

Traders make one of two things. Either they make money, or they make excuses. When they make money, performance does the talking. When they don't, they scramble for excuses. Short sellers are the perfect scapegoats. The most vitriolic critics of short sellers are not exactly fund management nobility.

Besides, it might be counter-productive in the long term to blame short sellers for one's misfortunes. There are only two ways you can live your life: as a hero or as a victim. A hero takes responsibility, lives up to the challenges, and triumphs over adversity. A victim will blame others for their failures. The "patriots" who blame short sellers choose the path of the victim. Next time asset allocators decide on their allocation, who do you think they would rather allocate to: heroes or victims?

Now, do short sellers really decimate pensions? The single most important question about your own pension is: "do I want to retire on stories, or do I want to retire on numbers?" The day after your retirement, what will matter to you: all those buzz investment themes or the balance in your bank account?

If you think they are one and the same, then keep churning, and wait for either the handshake and the gold watch, or the tap on the shoulder from the line manager for a life-altering conversation. If you choose to retire on numbers, however, then let's have a look at them.

Nothing illustrates the "story versus numbers" dichotomy better than the active versus passive investing debate. Active management refers to fund managers taking bets away from the benchmark, a practice referred to as active money. Passive investing refers to minimizing the tracking error by mimicking the index. Active managers claim their stock-picking ability and portfolio management skills deliver superior returns. However, the numbers tell a different story. According to S&P's Index versus Active reports, the vast majority of active managers underperform the S&P 500 benchmark on 1, 3, and 5 year-horizons. This means that their cumulative compounded returns are lower than the benchmark. Exchange-Traded Funds, or ETFs, fared better than active managers every year on record, even during the most severe market downturns.

The proof is in the pudding. The burden of proof is no longer on ETFs but on active managers to prove that they can deliver more than the index. The debate has gradually shifted from "which manager should we allocate to?" to "remind me again why we should be going with an expensive underperforming benchmark hugger when there is a liquid, better, cheaper alternative?"

Unfortunately, there is more. The penalty for deviating from the benchmark is severe. If managers deviate and outperform, they are knighted as "stock pickers." Yet, when they stray and underperform, they are dubbed as having "high tracking errors." This often leads to redemptions, the kiss of death for fund managers. When the choice is between becoming a hero or keeping your job, self-preservation compels active managers to mirror the benchmark, a practice referred to as closet indexing. This is the famous "no-one ever got fired for holding [insert big safe blue-chip stock here…]" line. If active managers end up mirroring their benchmark, then the "active versus passive" debate is a misnomer. It really comes down to a choice between low-cost indexing via an index fund versus expensive closet indexing via a self-preserving active manager. Either way, you get the same index, but with the latter, you also have to pay a middle-man, called an active manager. As John Boggle, founder of Vanguard, used to say: "in investing, you get what you don't pay for."

That does not mean active management should die an unceremonious death. There are exceptional active managers worth every penny of their management fees. It simply means that the average active mutual fund manager gives active management a bad name. Investors who go down the active management route not only take an equity risk premium. They also take an active management risk premium. The current crisis of active management is nothing but the time-honored routine of the middle man in every industry who realizes that they can no longer delay efficiency.

Next, let's look at what happens during bear markets. Markets have returned between 6.3% and 8% on average. Compounded returns over a century are astronomical. So, in theory, you should stay invested for the long run. Explain that again to the cohorts who retired in 2001 and 2009. Markets have gone down 50% twice in a decade. When the response to "too big to fail" and "too much leverage" was to make them bigger, hyper-leverage, and put the same people responsible for the GFC back in the driver's seat, rest assured that markets are bound to hit "soft patches" again. Long-only active managers may display heroic grace under fire during bear markets but, when your net worth has gone down by 50%, a 1 or 2% outperformance is a rounding error. Two double diamond black slopes in a decade and everyone wants bear market insurance: "What should I buy during a bear market?"

Let us reframe the question. Imagine someone walking up to you and asking: "There is a bull market going on. What should I be short selling?" Pause for a second and then consider your reaction. If selling a bull market does not make any sense, then why would you buy anything during a bear market? There is no safe harbor asset class that will magically rise. The only thing that goes up in a bear market is correlation. There will be ample time to buy at bargain-basement prices once the rain of falling knives stops.

During a bear market, the only market participants who can guarantee a reasonable rate of return are those whose mandate is inversely correlated with the index. These people are short sellers. You do not have to like them. You do not even have to stay invested with them during bull markets. More than any other market participants, they understand the cyclicality of inflows and redemptions. If you choose to retire on numbers, then you owe your pension to consider allocating to short sellers.

This brings us to a counter-intuitive conclusion. If you choose to retire on numbers instead of stories, then passive investing is the way to go on the long side. For capital protection and alpha generation during downturns, investors need to allocate to short sellers. In the active management space, the only market participants who will deliver a reasonable rate of return on your pension are short sellers.

Another counter-intuitive conclusion for practitioners is evolution. Active fund managers face an unprecedented existential crisis. If they want to survive, they need to evolve, adapt, and acquire new skills. Short selling might very well be a rare skill uniquely suited to market participants who are determined to stay relevant.

"Round up the usual suspects."

– Capitaine Renaud, Casablanca

When the real estate bubble burst in 2007, what were the short sellers in the risk committee and boards of directors at Lehman Brothers doing? Nothing. They did strictly nothing to prevent or remedy the situation because none of them ever sat on any of those committees. In the history of capitalism, no short seller has ever sat on the board of directors of a company whose stock they were selling short.

We can agree that fundamentals drive share prices in the long run. The driving force is the quality of management. Mark Zuckerberg is the genius behind Facebook. Warren Buffett turned an ailing textile company named Berkshire Hathaway into an industrial conglomerate. Jeff Bezos built Amazon. Steve Jobs 2.0 was the architect of Apple's renaissance. If top management is so eager to take credit for success, then it should equally be held responsible for failure. Steve Jobs 1.0 ran Apple into the ground. Kay Whitmore buried Kodak. The responsibility for Bears Stearns, Lehman Brothers, Merrill Lynch, and AIG falls squarely on the shoulders of those at the helm. Short sellers did not make any of the bad decisions that destroyed those companies. Bad management makes bad decisions that lead to bad outcomes, the same way that good management makes good decisions that lead to good results.

No one captured what happens at the highest echelon of companies better than Steve Jobs in his 1995 Lost Interview. He mentioned that "groupthink" amidst the rarefied atmosphere of top management in venerable institutions sometimes leads to a cognitive bias called the Dunning-Kruger effect. As an example, Kodak was once an iconic brand. Management believed they were so ahead of the game they could indefinitely delay innovation. They took a step backward to their old core technology when the world was moving forward. As tragic as it was back then, there is no flower on Kodak's grave today. The world, and even the 50,000 Kodak employees laid off, have moved on. Today, Kodak is a case study in the failure of management to embrace innovation.

Top management love to surround themselves with bozocrats, non-threatening obedient "yes-men," whose sole purpose is to reassure the upper crust of their brilliance, reinforcing a fatal belief in infallibility. Dissent is squashed. Innovation, branded as cannibalization, is swiftly buried in the Kodak sarcophagus of innovation.

Top management becomes so infatuated with their brilliance that they do not even realize they are detached from reality. Given sufficient time, their obsolete products destroy them from the inside. Short sellers simply ride arrogance to its dusty end.

The history of capitalism is the story of evolution. During World War I, the dominant mode of transportation was the horse. On the first day of World War II, the world woke up in horror to a German panzer division mowing down the Polish cavalry. The cruel lesson is that evolution does not take prisoners. Out of the hundreds of car manufacturers between the two world wars emerged a few winners. The rest of the industry went out of business. For every winner, there are countless losers. Today, everyone is perfectly happy with horse-carts running around Central Park, but no one sheds tears over the defunct horse-cart industry. Everyone has forgotten the names of all those small car manufacturers. The world has moved on.

We often see the S&P 500 as this monolithic hall of corporate fame and power, but we forget that since the index was formed in 1957, only 86 of the original 500 constituents are still in the index. The other 414 have either gone bankrupt or been merged into larger companies. Radio Shack did not go out of business because of short sellers. It went out of business because it could not evolve to face the competition of Amazon and the likes of Best Buy. Short sellers do not destroy companies. They escort obsolescence out of the inexorable march of evolution.

"Price is what you pay, value is what you get."

– Warren Buffett

Market commentators love to put a dollar sign on the destruction of value every time share prices tank. The net worth of Mr Zuckerberg shrank by $12 billion on July 26, 2018. Since short sellers stand to profit from the drop, they are guilty of value destruction by association. For example, George Soros is often associated with the fall of the British pound in 1995. How could one man single-handedly bring down the currency of one of the wealthiest nations on earth? He bet big on the Bank of England's unsustainable stance.

At the heart of this is a confusion between intrinsic and market values. One is value, the other is valuation. Intrinsic value is the net wealth companies create through the sale of products and services. Market value is the price market participants are willing to pay. Market and intrinsic value live in parallel universes that rarely intersect. One is hard work. The other is the fabled Keynesian beauty contest. The bottom line is that shareholders do not create any more value than short sellers destroy any.

"I am soft, I am lovable. But what I really want to do is reach in, rip out their heart, and eat it before they die."

– Richard Fuld, fallen angel, on short sellers

People often forget that when Steve Jobs returned to the helm, the iconic logo once again made the cover of magazines in a casket. Amazon was not always the darling of Wall Street. What is now considered visionary management was, for a long time, branded as stubborn disrespect for shareholders.

When executives whine about vicious rumors spread by short sellers and their agents, they forget that Steve Jobs and Jeff Bezos had to stomach the same vitriol for years. They came up with the best antidote against short sellers. Make products that sell, manage your company properly, and short sellers will go away. Today, no short seller would ever take a stab at Apple. Note to all CEOs, the vaccine against short sellers is: put the interests of the company, its employees, its customers, the environment, its shareholders, and its management in that order and things will be fine.

If your approach is instead to hollow out resources from R&D, customer service, randomly "restructure" personnel, and flatten the organization chart, to engage in aggressive accounting practices, and vote for ridiculous stock option plans for the board, to gobble up sterile acquisitions and, above all, finance share buy-back plans, then, one day, there will be a pot of gold on the other side of the rainbow to be shared among short sellers.

In 2007, Mathew Rothman, global head of quantitative research, published a note about the demise of quants that went on to become the most circulated piece of research in the history of Lehman Brothers. As the battle between short sellers and Lehman escalated, he showed top management a white paper from Owen Lamont entitled Go Down Fighting: Short Sellers vs. Firms. Richard Fuld was not amused. He blamed short sellers for spreading vicious rumors that drove Lehman's share price down. A decade later, the dust settled. Every other article about the GFC and banker's hubris is illustrated with a picture of Richard Fuld's testimony before the House committee. Being the poster child of the GFC is a rough way to go down in history, even by cold calculating investment bankers' standards. My heart goes out to Mr Fuld…

However, if all it took to bring down companies, markets, and currencies were bad breath, colorful language, and small positions relative to the overall float, then faith in capitalism should join the great white shark and polar bear in the list of endangered species. The national sport of short sellers is to unveil paradoxes in the fabric of the corporate space-time continuum. Ignorance and competence cannot exist in the same place at the same time. Basically, you cannot pretend to know what you are doing if you don't know what is going on. Strangely enough, this is a lie embattled CEOs would like us to believe. Whenever they are questioned about the illicit activities of their subordinates, their first line of defense is to feign indignation and throw them under the Bentley, pretending that they were unaware of the illicit actions perpetrated by a few isolated rogue individuals. That's commendable, except every single person on this planet knows that money does not grow on trees. Money leaves a trail. Bonuses are not charitable contributions.

Besides, company size is not a valid excuse either. For example, war is a dirty business. Generals are often far removed from the theater of operations. Yet, it does not mean their lowest-ranked soldiers can run around pillaging and looting with impunity. So, when CEOs claim they are not aware of fraud perpetrated by their underlings, either they are willfully blind and therefore complicit in the cover-up, or they really do not know what is going on and therefore incompetent. Either way, they are unfit for duty and undeserving of their compensation packages. That explains why, whenever short sellers uncover malfeasance, top management goes on the offensive and portrays short sellers as evil speculators who spread vicious unfounded rumors. Companies who have nothing to fear may not be happy, but they rarely waste time on legal action against short sellers.

Short sellers are the cicadas of the markets. No one has ever blamed cicadas for heralding the end of summer. When short sellers show up, this may herald the end of good times. They do not just talk trash. They put their money where their mouth is. If someone is willing to put capital at risk, the least long holders should do is revisit their bullish stance. Short sellers are often blamed for spreading vicious rumors and profiting from the decline. Companies will take analysts with Buy ratings for dinner and short sellers to court. Short sellers must therefore be careful about their facts and wording. Secondly, regulators do not take kindly to short sellers shorting across pension funds' large holdings. They are audited on a regular basis. Compliance is a survival mechanism. If your business model is to manipulate share price by spreading rumors and trade on it, then drop this book and go buy coffee mugs because "los federales" are about to establish a base camp in your meeting room.

"If we are victorious in one more battle with the Romans, we shall be utterly ruined."

– Plutarch on Pyrrhus

A word of caution for fellow short sellers. Short selling is an immature and fragile segment of the industry. On the one hand, short sellers want recognition for the value they bring to the markets. In the words of James Surowiecki, they balance out "Wall Street's inherent bullish bias," and play "a vital role in uncovering malfeasance." Short sellers also want to be treated fairly, just like any other market participant.

Yet, on the other hand, short sellers come across as the enemy for a good reason. Airing commercials or sponsoring documentaries to expose companies as frauds and  their management as crooks is a double-edged sword. Every successful campaign builds up resentment amidst corporations, regulators, and the public. Every short-term pyrrhic skirmish won makes the long-term victory ever more elusive. Many jurisdictions still ban short selling. Those that allow short selling have cumbersome administrative rules such as the uptick rule, an obligation to secure "borrow" before trading. The uptick rule stipulates that a short sale can only take place following an uptick in traded price.

Respect is never due but consistently earned. As long as short sellers fight dirty, they deserve to be treated with equal disdain. The most powerful incentive is probably the attitude of investors. Short sellers have such a sulfurous reputation that many investors will simply refuse to allocate to short sellers.

The premise of this book is that short selling does not have to be conflictual. Please be kind to top management. Do not remind them of their obsolescence. Time and markets are cruel enough already. The middle ground is simply to say you are shorting underperformers relative to the benchmark. Looking for relative shorts does not infuriate corporations, quite the opposite in fact. Every start up entrepreneur in Silicon Valley knows that markets have only two seasons, bull and bear. A bull market is series A and IPO season. A bear market is "go back working for the man" season. Executives in defensive sectors, such as food or utilities, do not expect their stocks to be assets of choice during bull markets. In fact, they would probably rescind their pension mandate to a manager who would gulp up their stock in a bull market, unless of course you are Warren Buffett and you talk to Coca-Cola.

"Not all is lost until the lesson is lost."

– Mother Teresa

Share prices may go up multiple times but can only go down 100%. Short sellers therefore open themselves up for infinite losses and limited profits. The not-so-secret dream of every fund manager is to pass their name down to posterity. "Managers" who just sit back watching their shorts going up multiple times against them deserve to have this dream come true. They have earned the right to have their name on a plaque… at the bottom of a public urinal. There is simply no excuse for bad risk management.

On a different note, meet Joe Campbell, a young dynamic entrepreneur, and investor in his spare time. On November 18, 2015, he sold short Kalobios (KBIO) at an average cost of $2 for a total market value of $33,000. Enter Pharma Bro, Martin Shkreli, who disclosed 50% ownership of Kalobios after the close. The share price roofed at 800% in the after-hours market. Borrow vanished overnight. Unable to meet his margin call, the unfortunate short seller appealed to the sympathy of fellow traders by launching a crowdfunding campaign on GoFundMe, only to face the humiliating double whammy of market participants "revenge trading" vitriolic comments. My sympathy goes to Mr Campbell and may at least his story serve as a lesson to aspiring short sellers:

• Penny stocks are tourist traps. Tourists do not care about the quality of borrow. They salivate over the story. When a recall happens, they scramble to locate. When no borrow is available, they are forced to cover, which eventually snowballs into short squeezes.
• Penny stocks are binary events. Either they go to zero, or there is a corporate action, and the share price goes ballistic. Penny stocks are high-risk, low reward trades. Get a few dan on your black belt before taking on Bruce Lee. 90% of market participants are unprofitable. The majority of the remaining 10% still refrain from short selling.

If it is any solace to Mr Campbell, Pharma Bro has since become a convicted felon.

"Facts do not cease to exist because they are ignored."

– Aldous Huxley

Short selling is risky. Not knowing how to sell short is, however, a lot riskier. Market participants are not risk-averse when they choose not to learn the craft. They are conservative to the point of being risk-seeking. Think of it as emergency drills. A refusal to practice the drills does not make the risks of fire, tsunami, or earthquake go away. People choose to go about their business unprepared for rare but life-threatening events. Being a market participant is not just about buy-and-hope, fair-weather sailing. Things can, and will, get rough.

At a subconscious level, every single market participant has this nagging subconscious fear of a bear market around the corner. They know they will give back some of the gains. Their best-case scenario is to sell before the bear and wait it out. This sometimes drives them to sell too early and miss out on big moves. As Peter Lynch said: "Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves."

Since no amount of academic research is ever going to drive the point across, let's look inside and play a game. Pick two pieces of paper, draw two columns. On the first one, write down your fears about bear markets. What is going to happen to your gains, portfolio, net worth, and job? How do you prepare for it? Be specific about when and how it manifests in your daily work. For example, do you check the markets more often than you think you should? Do you scan news for potentially bearish catalysts? Are you overly conservative or do you take risky bets while you think you can?

Next, imagine you were so serene about your ability to make money in down markets as to casually say: "Bull markets. Bear markets. They all taste like chicken." What would you do differently? Would you hold your positions longer? Would you size them differently? Would you be checking the news all the time? Write all the feelings on the second piece of paper. Once this is done, pick the first piece of paper and address all the fears one by one in the right-hand column. About half of your fears are emotional vampires that rob you of energy. They dissipate under the light of logical scrutiny.

Deep down, we all know that not being able to sell short is a lot riskier than not shorting at all because it gives you the ability to profit from both bull and bear markets.

In 2008, banking top executives were contemplating the abyss from the parapet of their corner offices. The banking lobby promptly marched up to Washington to demand a moratorium on short selling. In response, the U.S. Securities and Exchange Commission (SEC) put a temporary ban on short selling in the country in an effort to "restore equilibrium to the markets." This was lifted a short time later. Once the dust had settled, some analysis was done on the effect of the short selling ban, and the Federal Reserve published a report in which they concluded that short selling actually reduces volatility.

In the boxing ring called the stock market, it is not every day that the U.S. Federal Reserve is in the corner of short sellers. Without further ado, see the opening paragraph of their report:

"In response to the sharp decline in prices of financial stocks in the fall of 2008, regulators in a number of countries banned short selling of particular stocks and industries. Evidence suggests that these bans did little to stop the slide in stock prices, but significantly increased costs of liquidity. In August 2011, the U.S. market experienced a large decline when Standard and Poor's announced a downgrade of U.S. debt. Our cross-sectional tests suggest that the decline in stock prices was not significantly driven or amplified by short selling. Short selling does not appear to be the root cause of recent stock market declines. Furthermore, banning short selling does not appear to prevent stock prices from falling when firm-specific or economy-wide economic fundamentals are weak, and may impose high costs on market participants."

Market participants sell short for various reasons. Options traders, convertible managers, and indexers need to delta-hedge their positions. The inability to sell short reduces liquidity and the offering of financial products. Restrictions on short selling are therefore a sign of market immaturity.

Short sellers simply do not have the firepower to torpedo share prices. Short sellers need to borrow shares in order to sell short. This comes from shareholders who lend a fraction of their holdings to stock loan desks. Borrow availability usually averages less than 10% of the free float, in other words, the portion of shares available to public investors. This means that short sellers represent a fraction of the overall sell volume.

The BB guns of short sellers may have a punctual market impact, but the real damage is inflicted by the heavy artillery of institutional investors selling. This leads us to an interesting point about short selling. Making money on the short side is not about spotting stocks that could potentially go down. It is about riding the tail of institutional investors liquidating their positions.

"The best time to fix the roof is when the sun is shining."

– John F. Kennedy

Some market participants do not want to sell short during bull markets. They lament the scarcity of "good short ideas." Besides, they do not want to trail their competitors by wasting precious alpha shorting stocks. They procrastinate about sharpening the saw until it is rusty.

No bull market has ever boosted anyone's IQ. Market participants do not get smarter in bull markets; they become complacent. Just as waiting for a first heart attack to get in shape is not healthy, waiting for a bear market to learn short selling is an unprofessional way to manage other people's money. Short selling is a muscle that atrophies when not flexed.

The reason why investors keep their money in long/short funds is downside protection. Investors will forgive mediocre performance and stomach high fees through a bull market as long as they know there is downside protection in a bear market.

Beta jockeys believe there will be ample time to pick up short selling when the broader market turns bearish. After all, the outer game of short selling, tools, and techniques may be a little more sophisticated than the long side, but it is not rocket science. Short selling is, first and foremost, an inner game. Do not underestimate the time it takes to internalize the mental discipline of short selling.

The wrong time to start is when the long side is hemorrhaging money, and investors are breathing down your neck.

"With great power comes great responsibility."

– Uncle Ben, Spider-Man

Structural shorts are stocks perceived as irreversibly doomed; horse carriages in the 1930s, print papers in the digital age, and coal mines in the renewable energy era. They are supposedly compelling shorts because the dynamics of their business models or industries are structurally flawed.

Structural shorts are as cheap as market gurus flapping their mouths in the media, a dime a dozen. Profitable structural shorts are the unicorns of the financial services industry, as rare and elusive as market wizards.

In Chapter 3, Take a Walk on the Wild Short Side, we dispel the myth of structural shorts. For now, let us focus on what it means to look for structural shorts when managing other people's money. Market participants have held the comfortable belief that somewhere out there, there is a stock that they just can sell short and throw away the key. Since it will see itself to bankruptcy, it does not need any further maintenance.

Now, they do not hold reciprocal beliefs about their longs. Of course, they believe they require continuous maintenance. They believe in meeting with management, updating earnings models, calls with analysts, and so on. So, they believe in rigorous work ethics on the long side and passivity on the short side. In the real world, everyone knows that the short side is considerably harder than the long. So, how come complacent laziness would work on the difficult side when hard work barely pays off on the easy one?

When people publicly hold this kind of asymmetrical unquestioned beliefs, the inconvenient truth is that they have not given much thought to the short side. They do not know how to sell short. They have obviously not tried very hard either. If they had, reality would quickly have slapped them into submission. Yet, they still hope things will magically take care of themselves. They confidently market a skill they do not possess, happy to take on other people's money and milk generous fees. Yet they have no intention of taking responsibility for the inevitable discomfiture. In the Queen's English, this is called dereliction of duty. In execution trader English, those individuals are called clowns. For the rest of the book, let's embellish their status to chrematocoulrophones (chremato: money, coulro: clowns, phones: voice).

Short selling has long been this terra incognita on our doorstep. There are more books and whitepapers published in relation to modern techniques such as artificial intelligence or machine learning than short selling, which has been around for centuries. Dispelling myths is particularly important if we want to give the technique a letter of nobility, rehabilitate the discipline, and attract talented minds.

In the next chapter, we will discuss the market dynamics of the short side and explain how a deep understanding of them is critical to success.