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.
- 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.
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:
- Only about 18% of shares outstanding are available to be borrowed, and only about 4% are actually on loan at any given point in time.
- The median loan fee is only 11 basis points (bps) per year. However, fees exhibit considerable skewness—the mean fee is 85 bps and the 99th percentile fee is 1,479 bps.
- The average stock experiences dramatic variation in its loan fees over time, creating shorting risk.
- Loan fees increase significantly when past returns are in either the highest or the lowest quartile of returns.
- Loan supply levels fall when past returns are high, precisely when it is costliest for a short-seller.
- The median loan is open for approximately 65 days, indicating that short-sellers often hold their position open for several months and thus are exposed to changes in loan fees.
- Short-selling risk’s return predictability holds after controlling for a variety of firm characteristics. The authors’ model can explain 97% of the variation in one-month-ahead short-selling risk.
- Stocks in the low-short-selling-risk quintile earn monthly returns of 0.58%, while stocks in the high-short-selling-risk quintile earn monthly returns of -0.49%. The data was statistically significant at the 1% confidence level.
- A long/short portfolio formed based on shorting risk earns a 9.6% annual five-factor alpha.
- The results are strongest among micro- and small-cap stocks, though the results hold for large stocks.
- The ability to predict returns is greatest among stocks with high short-selling risk.
- Short-selling risk is associated with significantly larger price delay. A one-standard-deviation increase in shorting risk is associated with a 6.8% increase in price delay.
- The results hold after controlling for other known predictors of returns, including liquidity and idiosyncratic volatility.
- A one-standard-deviation increase in short-selling risk is associated with a 10.6% decrease in short volume relative to its unconditional mean—short-sellers trade less when short risk is high over the expected holding horizon of their trade.
Engelberg, Reed and Ringgenberg concluded: “Higher short-selling risk appears to limit the ability of arbitrageurs to correct mispricing, and as a result these stocks earn lower future returns.” They added: “Why don’t other investors arbitrage away the predictive ability of short interest? Our results provide a partial explanation: short selling is risky.”
Engelberg, Reed and Ringgenberg showed that high short-selling risk is associated with decreased price efficiency and less short selling by arbitrageurs—short-selling risk helps explain why there is so little short selling. That risk allows pricing anomalies to persist even though they are well-known.
The finding that only a small proportion of shares outstanding is available for lending at any time, even in a market as liquid as the United States, helps explain why equilibrium prices in the equity market can be too high.
This result really shouldn’t be a surprise. In the paper “Risk, Uncertainty, and Divergence of Opinion,” which appeared in the September 1977 issue of The Journal of Finance, Edward Miller explained: “Given divergence of opinion, stronger short selling constraints result in more overvaluation. This occurs because constraints prevent the negative views of some traders from being impounded into price.”
Investors can benefit from this knowledge without shorting stocks. They can do so by avoiding the purchase of high-sentiment stocks where borrowing fees are “on special” and the supply of shares available for borrowing is low.
Both Bridgeway and Dimensional Fund Advisors account for short fees when considering whether to include a stock on their list of those eligible for purchase. (Note that this is one of many ways intelligently designed, passively managed funds can add value over pure index funds, which seek to eliminate tracking error.) (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Bridgeway and Dimensional funds in constructing client portfolios.)
However, if you wanted to be very aggressive and sell the high-rebate-rate stocks you currently hold to avoid the underperformance, you would not only forgo lending revenue, you would want to buy back the stock once the high short fee falls. Thus, you would incur additional trading costs.
It doesn’t seem likely that the benefit of avoiding what is estimated to be about 17 bps of underperformance per month would be worth the round-trip trading costs, especially because high-shorting-cost stocks tend to be small-caps, which have large bid/offer spreads, and you would be demanding liquidity when selling.
In addition, Itamar Drechsler and Qingyi Drechsler, authors of the July 2014 study “The Shorting Premium and Asset Pricing Anomalies,” found that about one-quarter of “on special” stocks migrate into lower-cost buckets each month. In other words, underperformance tends to be fleeting.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.