ASIC boss, Tony D’Alosio told a Senate Committee Hearing last week that the watchdog will investigate whether hedge funds had colluded to short-sell stocks, forcing over-leveraged executives into a “margin call” position.

While ASIC should target market manipulation, the investigation is a waste of time on two fronts. First, the chances of actually obtaining evidence of such behaviour that would hold up in court is virtually zero. Second, even if the allegations are correct, it is arguable that short-selling may be a good thing and not the act of the devil, as has been claimed by some.

Basically, short-selling involves selling a share without actually owning it – the person who is “short” is hoping that the share drops in value. Ultimately, the short-seller needs to buy the share back at a later date. On a practical basis, short-selling generally occurs by “borrowing” shares from a broker and then selling them on the market. Short-selling is most commonly undertaken by professional investors and hedge funds (although CFDs are now allowing smaller investors to short ASX200 stocks).

Financial planner, Noel Whittaker writing in the Courier Mail was highly critical of such tactics, especially shorting stocks in order to trigger margin loans. Whittaker claimed that:

The growing popularity of margin lending is another factor that works in favour of the traders. The traders prefer shorting shares that are favourites of investors who use margin lending because they know that the selling pressure and price slumps caused by short selling will trigger margin calls for those investors who are heavily geared.

Despite Whittaker’s objections, it is arguable that over-leveraged executives whose companies are a debt-funded house of cards, like MFS, deserve to be exposed by traders such as hedge funds. If a company has been overvalued by the market (as MFS, Centro and Allco all were), all the short-sellers are doing is forcing the company to trade at a value closer to its intrinsic value. If executives chose to hold highly leverage stakes that is their choice, but blaming the hedge funds is no different to shooting the messenger.

In MFS’ case, the villains of the story are without doubt, executives Michael King and Phillip Adams (and their non-independent board and auditors), who spent billions of dollars of shareholders’ funds overpaying for assets. Not only did MFS use an enormous amount of debt at a corporate level, but the owners also funded their equity positions with debt – effectively piling leverage upon leverage. That is all fine so long as investors are willing to pay an increasingly high price for the shares.

When MFS revealed on 18 January as requiring an urgent injection of $550 million, the jig was up. Shareholders rushed to dispose of their holdings while hedge funds, immediately noticing that the stock was trading at well above its true value (which was probably close to zero) wisely shorted the stock. Hedge traders probably knew that King and Adams’ stakes were highly leveraged but that doesn’t make what they did wrong.

Strangely, no one seemed to complain when share prices were being irrationally forced upwards, due to hedge fund speculation or executives using debt to acquire larger stakes. Nor did any executive ever complain that hedge funds had manipulated the market upwards, causing share prices to rise too far (and possibly allow those very executives to cash in reams of options).