The important role played by short sellers, who by their actions keep prices efficient by preventing overpricing and the formation of price bubbles in financial markets, has received increasing academic attention in recent years. Research into the information contained in short-selling activityi has consistently found that short sellers are informed investors who are skilled at processing information (though they tend to be too pessimistic). That is evidenced by the findings that stocks with high shorting fees earn abnormally low returns even after accounting for the shorting fees earned from securities lending. Thus, loan fees provide information in the cross-section of equity returns.
While retail investors are considered naive traders, the authors of the 2020 study, “Smart Retail Traders, Short Sellers, and Stock Returns,” found that retail short sellers are informed traders who profitably exploit public information when it is negative. The theory is that the high costs, the risk of unlimited losses and the resulting absence of liquidity motivated short selling make short sellers more informed than average traders.
New research
Chen Chen and Licheng Sun, authors of the April 2023 study, “Swim with Sharks: Are Short Sellers More Informed than their Competitors?,” examined the interaction between short sellers and other traders to determine who were the most informed. To measure private information (informed trading), they used the probability of informed trading (PIN) model, which estimates private information from transaction-level data from the Trade and Quote (TAQ) database and has been shown to have the ability to capture private information signals. They also decomposed the PIN into two parts: PIN following good news (PIN G) and PIN following bad news (PIN B). They sought the answers to three empirical questions:
1. Do short sellers possess superior information? If so, we would expect heavily shorted stocks to underperform lightly shorted stocks.
2. Do PIN G and/or PIN B have any predictive value? If they do, we should expect statistically significant results for informed buying but insignificant results for informed selling.
3. Are short sellers more informed than other types of informed traders (especially informed buyers)? If so, if the stocks favored by informed buyers are subject to heavily short selling and their adjusted returns are negative, it indicates short sellers are more informed and vice versa.
Their data sample was the Financial Industry Regulatory Authority’s (FINRA) historical data and covered the period August 2009-December 2019. To calculate returns, they skipped one day (day 1) and held the portfolios for the next 20 days (from day 2 to day 21) to alleviate concerns about any possible microstructure effects. The portfolios were rebalanced daily. Returns were benchmarked against the Carhart four-factor (beta, size, value and momentum) model. Following is a summary of their findings:
- Confirming prior research, short sellers are informed traders – heavily shorted stocks significantly underperformed lightly shorted stocks, especially among small-cap firms. The results were also economically significant, as the annualized high-minus-low shorting flow spread for high (low) PIN G stocks was -21.29% (-11.82%), indicating that short sellers are well informed and that the market is slow to incorporate public shorting information into prices. However, similar results were not found with PIN B stocks. For example, among stocks with the highest shorting flow, the alphas were negative and significant among low PIN B stocks but insignificant for high PIN B stocks. The mean difference between high and low PIN B stocks was also insignificant.
- Conditional on the strength of short selling, buyers tended to be more informed than sellers.
- There was a positive relation between the strength of short selling and informed buying, but the relation between short selling and informed selling was ambiguous.
- High PIN G stocks tended to outperform low PIN G stocks only when short selling was light. When short selling was heavy, high PIN G stocks underperformed low PIN G stocks.
- The battle of the informed was won by the short sellers. When both short selling and informed buying were intense, future stock returns were significantly negative – short sellers had the upper hand in this duel of the informed traders.
- Among heavily shorted stocks, stocks favored by informed buyers earned significantly negative average returns. In addition, the alpha spread between stocks favored and disliked by informed buyers was also significantly negative.
- Similar patterns were not found among stocks favored by informed sellers – the competition from informed sellers has reduced the informativeness of short selling.
- Among lightly shorted stocks (lowest shorting flow quintile), stocks with more informed buyers (high PIN G) earned higher alpha and vice versa for stocks with low PIN G. This finding is consistent with the view that informed buyers’ orders have predictive value, especially when their trading actions are not against short sellers.
- Their findings were strong among small firms and firms with smaller differences in analyst forecasts—smaller firms are more difficult and costly to short; thus, the presence of heavy short selling in these firms sends a clear signal about their overvaluation status.
Their findings were robust to adjustments for microstructure noises, short-sales constraints and alternative methods of order classifications.
Implementation
Given the low expected performance of heavily shorted stocks, the ideal situation is to find a way to avoid holding them. If the stocks are held, securities lending revenue could provide a hedge that partially offsets their expected underperformance. Not participating in securities lending is forfeiting that partial hedge. The package of securities lending revenue plus the expected stock performance should be analyzed together; neither should be considered in isolation.
The research on short selling has led some “passive” (systematic) money management firms (such as AQR, Avantis, Bridgeway and Dimensional) to suspend purchases of small stocks that are “on special” (securities lending fees are very high). Dimensional has done extensive research on securities lending, confirming the findings of academic researchers. Using data for 14 developed and emerging markets from 2011 to 2018, it found that stocks with high borrowing fees tended to underperform their peers over the short term. Moreover, stocks that remained expensive to borrow continued to underperform, but persistence of high borrowing fees was not systematically predictable. While the information in borrowing fees is fast decaying, it can still be efficiently incorporated into real-world equity portfolios.
Dimensional also found that while high borrowing fees were 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 showed there was relatively high turnover in the group of stocks that were on loan with high borrowing fees. For example, fewer than half of high-fee stocks were still high-fee one year after being identified as such. Therefore, excluding those stocks may lead to high costs if buy and sell decisions are triggered by stocks frequently crossing the high-fee threshold. After considering the trade-offs between expected return, revenue from lending activities, diversification, turnover and trading costs, Dimensional believes that an efficient approach to incorporate these findings into a real-world investment process is to consistently exclude from additional purchase small-cap stocks with high borrowing fees. Bridgeway takes a similar approach.
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 borrowing fees and shorting. AQR also uses the information in some of its 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 were predictive of lower returns even net of their higher fee.
Individual investors can also benefit from the research findings without shorting stocks. They can do so by avoiding purchasing high-sentiment stocks where borrowing fees are “on special.”
As noted, short sellers play a valuable role in keeping market prices efficient by preventing overpricing and the formation of price bubbles in financial markets. It is the limits to arbitrage, the high risks, and the high costs of shorting that allow some inefficiencies to persist, explaining the information provided by short sellers. The recent GameStop episode in which retail investors banded together to engineer a short squeeze demonstrated just how risky shorting can be, with the potential for unlimited losses. That type of risk was one that had never been experienced and almost certainly was not expected.
Compounding the risks of shorting is that, as Xavier Gabaix and Ralph Koijen demonstrated in their 2021 study, “In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis,” markets have become less liquid and thus more inelastic. Gabaix and Koijen estimated that $1 in cash flows results in an increase of $5 in valuations. One explanation for the reduced liquidity is the increased market share of indexing and passive investing in general. Reduced liquidity increases the risks of shorting. Adding further to the risks is the now-demonstrated ability of retail investors to “gang up” against shorts (who might be right in the long term but dead before they reach it). The limits to arbitrage have now increased, allowing for more overpricing of “high sentiment” stocks, making the market less efficient.
Investor takeaways
A large body of evidence demonstrates that short sellers are informed investors who play a valuable role in keeping market prices efficient – short selling leads to faster price discovery. Fund families that invest systematically, such as those mentioned above, have found ways to incorporate the research findings to improve returns over those of a pure index replication strategy. It seems likely this will become increasingly important, as the markets have become less liquid, increasing the limits to arbitrage and allowing for more overpricing.
Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners.
For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based on third party data and may become outdated and otherwise superseded with notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Neither the Securites and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy or adequacy of this information. LSR-23-507
i Including the 2016 study, “The Shorting Premium and Asset Pricing Anomalies,” the 2017 study, “Smart Equity Lending, Stock Loan Fees, and Private Information,” the 2020 studies, “Securities Lending and Trading by Active and Passive Funds,” and, “The Loan Fee Anomaly: A Short Seller’s Best Ideas,” and the 2021 studies, “Pessimistic Target Prices by Short Sellers,” and “Can Shorts Predict Returns? A Global Perspective.”
Read more articles by Larry Swedroe
The important role played by short sellers, who by their actions keep prices efficient by preventing overpricing and the formation of price bubbles in financial markets, has received increasing academic attention in recent years. Research into the information contained in short-selling activityi has consistently found that short sellers are informed investors who are skilled at processing information (though they tend to be too pessimistic). That is evidenced by the findings that stocks with high shorting fees earn abnormally low returns even after accounting for the shorting fees earned from securities lending. Thus, loan fees provide information in the cross-section of equity returns.
