As I recently discussed, the academic literature shows that short-sellers, while often demonized, play an important role in captal markets. For example, short-sale constraints prevent pessimistic opinions from being fully reflected in stock prices, allowing optimistic investors to drive price above their intrinsic value.
Studies have demonstrated 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. Furthermore, the research has found that expensive-to-short stocks (where borrowing fees are high) have low subsequent returns.
This is valuable information that even passively managed, long-only funds can put to use, as long as such funds aren’t forced to adhere to a pure indexing strategy where the sole goal is to minimize tracking error against the benchmark index.
Mutual funds can employ securities-lending revenue to enhance returns for fund shareholders. Traditionally, the value added from securities lending comes from the revenue generated from the spread between the return from investing a borrower’s cash collateral and the payment to compensate the borrower for posting collateral (also referred to as the “rebate rate”).
However, as mentioned, research on short-selling provides another way to enhance shareholder returns. Long-only funds can delay the purchase of stocks that are in their eligible universe when the demand from short-sellers to borrow securities drives security-lending fees to very high levels.
A recent research paper from Dimensional Fund Advisors (DFA) on the subject found that stocks whose lending fees are 10 basis points or more above the fee for what is referred to as “general collateral” dramatically underperformed over the succeeding 12 trading days.
When the lending fee goes on “special”—meaning the lending fee is more than 20 basis points more than the fee for general collateral—the stocks have the worst performance. On an equal-weighted basis, they underperform over the following 12 days by more than 30% per year. In addition, all the data shows strong statistical significance.
These specials tend to be in small-cap stocks, where there is often a limited supply of securities available to lend (institutions tend to underweight these stocks, and it is institutions that do the vast majority of securities lending). Even long-short funds can short such stocks (despite the high lending fees) because these stocks go on to have very poor returns.
Passively managed funds from firms such as AQR, Bridgeway and DFA have used this knowledge as a means to enhance returns and add value where a pure index fund cannot, because it doesn’t want to accept tracking error risk (underperforming its benchmark index).
And because funds managed by these firms are highly diversified, excluding a small number has an insignificant impact on diversification. (In the interest of full disclosure, my firm, Buckingham, recommends AQR, Bridgeway and DFA funds in constructing client portfolios.)
What’s An Investor To Do?
An interesting question is: Should investors who already own low-rebate stocks sell them? As DFA researchers explain in an October 2015 paper, “two considerations relevant to that decision are expected trading costs and lending revenue.”
They write: “While low rebate small-cap stocks have negative short-term expected returns relative to their peers, trading costs may be high for an investor demanding immediacy to sell and then repurchase a specific small- or micro-cap stock over a short horizon. Further, selling these stocks would eliminate the revenue generated for the portfolio by lending them.”
This exclusion process is just one of several ways a well-constructed passively managed fund can add value.
Another way to use this information is to place a preference on selling shares (in the “too-be-sold” bucket) that are on special. Similarly, they can add value by excluding other securities that the research shows have poor risk/return characteristics. Research has found that stocks with low prices, high volatility and high idiosyncratic volatility tend to have very poor returns. These stocks are often referred to as “lottery tickets.”
There are yet other ways to add value. Among them are the use of patient, algorithmic trading strategies (which allows a fund to be a seller, rather than a buyer, of liquidity) and the incorporation into fund-design added exposure to factors with historical premiums (such as momentum).
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.