The explosive rally in GameStop, pitting retail investors against hedge funds, has renewed calls to ban short selling. But new research shows how valuable short sellers are to the efficient functioning of markets.
The importance of the role played by short sellers has received increasing academic attention in recent years. The research has demonstrated that short sellers as a group are key market intermediaries who improve the informational efficiency of prices, increase market liquidity, and in doing so, improve the efficient allocation of capital. In addition, temporary short-selling bans have been found to impede pricing efficiency. Without short sellers, equity prices can become overvalued, as only the optimists are expressing their opinions on valuations.
The research has also found that even in the presence of short sellers, anomalies (mispricings) exist, as stocks can remain overvalued. Academic research has tried to explain why the anomalies continue to persist. Among the explanations are that there are limits to arbitrage, which prevent rational investors from exploiting the anomalies. For example:
- Many institutional investors (such as pension plans, endowments and mutual funds) are prohibited by their charters from taking short positions.
- Investors are unwilling to accept the risks of shorting because of the potential for unlimited losses. Even traders who believe that a stock’s price is too high know they can be correct (the price may eventually fall), but they face the risk that the price will go up before it goes down. Such a price move, requiring additional capital, can force the traders to liquidate at a loss.
- Shorting can be expensive – one has to borrow a stock to go short, and many stocks are costly to borrow because there are low supplies of available stocks from institutional investors (overvalued stocks tend to be overweighted by individual investors and underweighted by institutional investors, who are the lenders of shares). The largest anomalies tend to occur in small stocks, which are costly to trade in large quantities (both long and especially short), the volume of shares available to borrow is limited (since they tend to be owned by individual investors), and borrowing costs are often high.
- Stocks with high short fees earn abnormally low returns even after accounting for the shorting fees earned from securities lending. In other words, short sellers leave some scraps on the table.
At the end of 2018, U.S. mutual funds had $695 billion of outstanding securities loans,
representing over 80 percent of all outstanding short interest. The funds earned more than $2 billion in lending fees during the year, with 28 percent of active funds and 61 percent of index funds lending some of their portfolio securities.
New research
Pekka Honkanen contributes to the literature with his January 2020 study, “Securities Lending and Trading by Active and Passive Funds.” Honkanen studied the market for lending and borrowing securities in the United States. He used regulatory filings submitted to the SEC to construct a novel data set on securities lending by approximately 3,500 U.S. mutual funds. His data set contained about 23,000 fund-quarter observations from 2001 to 2017. Following is a summary of his findings:
- By making securities available for borrowing, mutual funds acquire information about short selling, which they exploit for trading.
- Funds with discretion in their investment choices rebalance their portfolios away from borrowed stocks, avoiding capital losses on stocks with decreasing prices. Active funds reduced their weight in borrowed stocks by about 2 percentage points compared to similar non-lender funds in the five quarters that followed a loan. Index funds showed no statistically significant deviation from similar non-lenders either before or after a stock was borrowed.
- Active funds trade more aggressively on stocks with stronger signals, reducing the supply of lendable securities (and likely increasing the problem of limits to arbitrage that allows mispricings to persist).
- Active funds charge lower lending fees than passive funds, consistent with funds paying for the information with lower fees.
- Stock prices declined on average 10% in the eight quarters following a loan from a mutual fund.
- Stock loans predict negative future returns that do not revert even 12 calendar quarters after the loan – stock loans are a valuable trading signal.
- Active funds avoided losses of about 11 basis points of portfolio value over the first eight quarters following a loan for each stock loan position relative to similar peer funds. The effect is small at the fund level. However, with the benefits of rebalancing positions, the improvement amounted to roughly 18% of the average position size of a stock on loan.
Honkanen also noted that because passive funds are less likely to take advantage of short sellers’ information or to “front-run” them, short sellers might prefer passive lenders. In support of this idea, he found that 63% of passive funds participate in the lending market compared to 48% of active funds. He also found that the fraction of portfolio value on loan for passive funds is up to three times higher than active funds. His findings led Honkanen to conclude: “Trading by active funds speeds up price convergence induced by short selling, which might contribute to improving price efficiency.”
Honkanen’s findings are consistent with that of prior research, including the 2016 study, “The Shorting Premium and Asset Pricing Anomalies.” The authors, Itamar Drechsler and Qingyi (Freda) Drechsler, found a large “shorting premium” – the cheap-minus-expensive-to-short portfolio of stocks had a monthly average gross return of 1.31%, a net-of-fees return of 0.78%, and a 1.44% four-factor alpha. They are also consistent with the findings of the 2017 study “Shorting Fees, Private Information, and Equity Mispricing.” Among the findings of the authors, Brian Henderson, Gergana Jostova and Alexander Philipov, was that “consistent with the ‘market frictions’ literature, the highest fees (a direct measure of short-sale constraints) are associated with the lowest returns – the highest shorting fees quintile earns -60 bps per month and underperforms the lowest fees quintile by 140 bps per month.” They concluded: “Results imply that the majority of short interest is actually uninformed and significantly influenced by discounted stock loan fees as well as by publicly available information related to trading frictions.”
Summary
Short sellers play a valuable role in keeping market prices efficient, allowing for the efficient allocation of capital. If short sellers were inhibited from expressing their views on valuations, securities prices could become overvalued and excess capital would be allocated to those firms.
The research on short selling has led some systematic money management firms (such as AQR, Bridgeway and Dimensional) to suspend purchases of small stocks that are “on special” (with very high securities lending fees). Dimensional has done extensive research on securities lending. Using securities lending data for 14 developed and emerging markets from 2011 to 2018, it found that stocks with high borrowing fees tend to underperform their peers over the short term. Moreover, stocks that remain expensive to borrow continue to underperform, but persistence of high borrowing fees is not systematically predictable.
While the information in borrowing fees is fast decaying, it can still be efficiently incorporated into equity portfolios. Dimensional also found that while high borrowing fees are related to lower subsequent performance, it is not clear this information can be used to make a profit by selling short stocks with high fees. Borrowing fees are just one cost associated with shorting; short sellers must also post collateral, typically at least 100% of the value of borrowing securities, and incur transaction costs. In addition, its research shows that there is relatively high turnover in the group of stocks that are on loan with high borrowing fees. For example, fewer than half of high-fee stocks are still high-fee one year after being identified as such. Therefore, fully excluding these stocks may lead to potentially high costs if buy and sell decisions are triggered by stocks crossing frequently the high-fee threshold.
After considering the tradeoffs between expected return, revenue from lending activities, diversification, turnover and trading costs, Dimensional believes that an efficient approach to incorporate these findings into an investment process is to consistently exclude from additional purchase small-cap stocks with high borrowing fees.
Avantis takes a different approach in designing its fund construction rules. It tries to avoid holding securities that tend to have characteristics associated with high lending revenues and shorting. AQR also uses this information in some of their portfolios – a high shorting fee is used as a signal to sell short the hard-to-borrow names, assuming AQR forecasts a positive expected return (net of the fee). It does so based on the academic evidence showing that high short-fee names are predictive of lower returns even net of their higher fee.
Finally, investors can benefit from the research findings without shorting stocks. They can do so by avoiding purchasing high-sentiment stocks where borrowing fees are “on special.”
The GameStop episode highlights the risks of selling short, with the potential for margin calls (you can be right in the long term, but "dead" before the long term arrives) and unlimited losses. With retail investors demonstrating the ability to band together and create short squeezes, the risks of selling short have increased. That increases the problem of limits to arbitrage, reducing the ability of sophisticated investors to correct overvaluation, allowing anomalies (mispricing) to persist. The likely outcome is that retail investors, who historically have overweighted stocks with poor historical returns (stocks with lottery-like distributions), while institutions have underweighted them, will be the ones negatively impacted by the reduced role short sellers may be willing and able to play in the future.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
Important Disclosure: My firm, Buckingham Wealth Partners, recommends AQR, Bridgeway and Dimensional funds in constructing client portfolios. Mentions of Avantis as a fund company are for illustrative purposes only. The analysis in this article is for information and educational purposes only and should not be construed as specific investment, tax, accounting, or legal advice. The information contained herein is based upon third party data and may become outdated or otherwise superseded at any time without notice. Certain information contained herein is based upon third party information and deemed to be reliable, but its accuracy and completeness cannot be guaranteed. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Strategic Wealth® / Buckingham Strategic Partners® (collectively Buckingham Wealth Partners) IRN-21-1341
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The explosive rally in GameStop, pitting retail investors against hedge funds, has renewed calls to ban short selling. But new research shows how valuable short sellers are to the efficient functioning of markets.
