Swedroe: Risks Of Short Selling

May 14, 2018

The importance of the role played by short-sellers has received increasing attention from academics in recent years. Research has demonstrated that short-sellers, as a group, are key market intermediaries who improve the informational efficiency of prices, increase market liquidity, and, by doing so, help lower country-level costs of capital.

In addition, temporary short-selling bans have been found to impede pricing efficiency. Without short-sellers, equity prices can become overvalued, because only optimists are expressing their opinions on valuations.           

Research has also found that anomalies (mispricings) exist even in the presence of short-sellers, as stocks can remain overvalued. As supporting evidence, research has found anomalies tend to be more pronounced on the short side. Academic research has tried to explain why these anomalies can continue to persist. Among the explanations are that limits to arbitrage prevent rational investors from exploiting the anomaly.

For example:

  • Their charters prohibit many institutional investors (such as pension plans, endowments and mutual funds) from taking short positions.
  • Investors are unwilling to accept the risks of shorting because short selling is a risky business. Short-sellers must identify mispriced securities, borrow shares, post collateral and pay a loan fee each day until the position closes. There is also the potential for unlimited losses. In addition to the risks of margin calls and regulatory changes, short-sellers face the risks of loan recalls and changing loan fees. Traders who believe a stock’s price is too high know they can be correct (the price may eventually fall), but still face the risk the price will go up before it goes down. Such a price move, requiring additional capital, can force traders to liquidate at a loss.
  • Shorting can be expensive—you have to borrow a stock to go short, and many stocks are costly to borrow, because low supplies are available from institutional investors. (Overvalued stocks tend to be overweighted by individual investors and underweighted by institutional investors, which lend shares.) The largest anomalies tend to occur in small-cap stocks, which are costly to trade in large quantity (both long and especially short); have a limited volume of shares available to borrow (because they tend to be owned by individual investors); and often come with high borrowing costs.
  • Stocks with a scarce supply of borrowable shares and high short fees earn abnormally low returns even after accounting for the shorting fee earned from securities lending. In other words, short-sellers leave some scraps on the table.

Additional Research

Joseph Engelberg, Adam Reed and Matthew Ringgenberg contribute to the literature on short selling with the study “Short-Selling Risk,” which was published in the April 2018 issue of The Journal of Finance. They hypothesized that stocks with more short-selling risk should have lower future returns, less price efficiency and less short selling.

They provided the following example: “Consider two stocks—A and B—that are identical in every way except for their short-selling risk. Specifically, stock A and stock B have identical fundamentals as well as identical loan fees and number of shares available today, but future loan fees and share availability are more uncertain for stock B than for stock A; that is, there is considerable risk that future loan fees for stock B will be higher and future shares of stock B will be unavailable for borrowing. Since higher loan fees reduce the profits from short selling and limited share availability can force short sellers to close their position before the arbitrage is complete, a short seller would prefer to short stock A because it has lower short-selling risk.”

In other words, a short-seller is concerned not only with the level of fees, but with fee variance. Thus, the authors focused on the variance of lending fees as their proxy for short-selling risk. Their database included 4,500 U.S. equities and covered the 5.5-year period from July 2006 through December 2011.

Following is a summary of their findings:

 

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