“Investing should be like watching paint dry or grass grow. If you want excitement, take $800 and go to Las Vegas”.

So said economics Nobel Laureate Paul Samuelson. For many investors, there has been a little bit too much excitement over the last 18 months - and not the happy excitement that leaves you with a big smile on your face, either.

One of the main factors, if you believe the media hype, has been hedge funds short-selling or “shorting” stocks, particularly of banks.

When the HBOS share price was plummeting in the summer, much of the blame was laid at the door of hedge fund managers. They were accused of betting that the price would fall while at the same time leaking rumours that HBOS was in trouble. This led to the bank’s their forced takeover by Lloyds TSB and a ban on short selling of 29 financial stocks listed in the United Kingdom.

But is shorting the great evil it is portrayed as, or does it provide a useful tool for investors and help keep listed companies up to the mark?

“Long” investing is buying an asset in the hope and expectation that it will rise in value. Your gain is the difference between the purchase and sale price.

“Short” investing is attempting to make a gain by predicting that the value of an asset will fall. This is generally done by selling a share you don’t own, at a given price, then buying it back to cover your position when the price has fallen. The gain is the difference between the selling price and the buying price, as with long investing, but the transaction is the other way round.

Hedge funds usually short shares by borrowing them from other financial institutions. They also use market derivatives such as put options to back their view that a share is likely to fall.

So why is this a problem for markets and individual investors? Short-sellers are widely regarded with suspicion because, in the views of many, they are profiting from the misfortune of others.

There is a feeling that short-selling can push markets from small-scale falls into crashes. An HBOS shareholder would have been looking on in horror over the summer as the value of his investment went into meltdown. Given the media reaction at the time, it would be understandable to feel that hedge funds and short-sellers had caused the loss.

However, it turns out that HBOS was already in trouble. When the shares stood at 750p in January, this was a massive overvaluation, given its balance sheet and business model.

Short-sellers claim they perform a useful service by seeking out overvalued businesses and returning their share price to a more realistic level.

“Long” investment guru Warren Buffett has stated that short-sellers perform a beneficial function in uncovering poorly or even fraudulently-run companies, such as Enron, acting as a counterweight to the over-optimism endemic in rising markets.

It’s also a common misconception that this is something new. Short-selling has been practised since stock markets began in 17th-century Amsterdam. It was a common practice in Britain to make use of the 30-day accounting period to go short on a stock. Debts did not have to be settled until the end of the month, allowing “bears” to sell stock they didn’t own at the start of the month in the hope of buying it later in the month at a lower price.

The main problem with short selling relates to the Samuelson quote. Most investors, private or institutional, buy assets for the long term. The best equity-fund managers, like Anthony Bolton and Neil Woodford, are looking to buy shares at low value to hold them for three to five years. They aim to benefit from a steady rise in the share price and dividends paid by the company.

Short sellers are essentially speculators. They rely on short-term price fluctuations to make money. This can increase volatility in the market and lead unscrupulous operators to talk down a stock to back their short position.

The issue is further complicated by the proliferation of UCITS III funds. These new regulations allow fund managers who previously ran long-only investment funds to use short-selling techniques to improve returns.

An investor may have invested in a long-only fund some time ago, only for the fund to convert to a so-called long-short fund. The investor no longer has the fund they invested in.

The risk has changed to something the investor may no longer understand. The fund manager may have a great record, but does he have the expertise to short-sell?

So if you receive a letter from your unit trust manager saying the fund has switched to UCITS III, it would be wise to ask a few questions.

Those who feel hedge funds and short-sellers are the devil’s henchmen saw a beautiful piece of poetic justice recently. Up to 100 funds were shorting Volkswagen shares on the assumption that the global downturn would hit their share price. Unknown to them, a secret buyer had taken up 74 per cent of VW shares.

When this was revealed, the hare price leapt from 210 Euros to over 1,000 Euros, leaving hedge funds with combined losses of £24 billion. The secret buyer? The manufacturer of the hedge fund managers’ car of choice: Porsche.

* Trevor Law is a director with Montpelier Group (Europe) Ltd, the  privately-owned independent financial advisers located at Barston near Solihull. E mail: TILaw@montpeliergroup.com