Swedroe: Short-Sellers Have Key Market Role

January 09, 2017

The academic literature demonstrates that short-sellers, while often demonized, play an important role in the capital markets. For example, short-sale constraints prevent pessimistic opinions from being fully reflected in stock prices, thereby allowing optimistic investors to drive prices above intrinsic value.

In fact, research has found that short-sellers are able to anticipate the public revelation that a company has misstated its financial statements and can predict negative earnings surprises, analyst downgrades and other negative company news. Additionally, researchers have found that expensive-to-short stocks (where borrowing fees are high) have low subsequent returns.

Findings such as these have led some “passive” money management firms (such as AQR, Bridgeway, and Dimensional Fund Advisors in its long-only funds) to suspend purchases of stocks that are “on special” (that is, where securities lending fees are very high).

Short Selling And Bonds
Stephen Christophe, Michael Ferri, Jim Hsieh and Tao-Hsien Dolly King, authors of the April 2015 paper “Short Selling and Cross-Section of Corporate Bond Returns,” contribute to the literature on short-selling by examining the impact of the short-selling of a company’s stock on that firm’s bonds.

They matched short-selling data with 156 individual bond issues available during their sample period, which ran from September 13, 2000 to July 10, 2001. The authors acknowledge the limitation that, “due to the propriety nature of the data,” their “sample period is relatively short.”

Their paper begins by noting:

  • Most corporate bonds are held by institutional investors and money managers, whereas stockholders are a more diverse group.
  • While the equity market is followed closely by financial analysts and the popular press, the corporate bond market is followed by a smaller number of sell-side bond analysts, and thus receives less coverage.
  • Although a bond’s creditworthiness is assessed by bond rating agencies, it is often observed that ratings significantly lag firm performance.

The authors then hypothesize that “the greater liquidity of the equity market and the stronger presence of unsophisticated retail investors could induce informed traders to use equity short selling as the primary tool for profiting from negative information about the overall firm because the market’s characteristics allow them to more easily disguise their trades. Moreover, if a negative information shock affects a firm’s fundamentals, which in turn changes its expected cash flows and/or risk, both stock and bond prices should decline. This anticipated reaction is quite intuitive, since both stocks and bonds represent claims on a company’s future cash flows.”

 

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