Swedroe: The Shorting Premium Puzzle

December 31, 2014

There are a number of well-documented anomalies that cause problems for the efficient markets hypothesis (EMH). These problems arise because the EMH assumes any mispricing in the market will be arbitraged away by rational traders who buy relatively undervalued assets and sell relatively overvalued ones.


Among the biggest problems are the existence of momentum and the relatively poor performance of small growth stocks—as well as any security with a lotterylike (or jackpot) distribution. These anomalies continue to occur even after they become known through the publication of academic research. The question is, Why, then, do such anomalies continue to persist?


One explanation offered by researchers attempting to answer this question is that there are limits to arbitrage, which prevents rational investors from exploiting the anomaly. For example:

  • Many institutional investors (such as pension plans, endowments and mutual funds) are prohibited by their charters from taking short positions.
  • Shorting can be expensive. You have to borrow a stock to go short, and many stocks are costly to borrow because the supply of equities available from institutional investors is low. The largest anomalies tend to occur in small stocks, which are costly to trade in large quantity (both long and especially short); the volume of shares available to borrow is limited, since they tend to be owned by individual investors; and borrowing costs are often high.
  • Investors are unwilling to accept the risks of shorting because of the potential for unlimited losses. Even traders who believe a stock’s price is too high know that, even though they might be correct and the price may eventually fall, they 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.


Malcolm Baker, Brendan Bradley and Jeffrey Wurgler—authors of the 2011 study, “Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly”—proposed another explanation; specifically, the typical institutional investor’s mandate to maximize the ratio of excess returns relative to a fixed benchmark without resorting to leverage.


Many institutional investors who are in a position to offset an irrational demand for risky assets have fixed benchmark mandates that are usually capitalization-weighted. Thus, straying from the benchmarks to exploit anomalies creates career risk.


The Fee For Shorting

Arbitrageurs can sell shares short by borrowing them in the stock loan market. The price for doing so is a fee, or rebate, paid by the borrower of the stock to the lender. The size of the fee should reflect underlying demand to short the stock.


Itamar Drechsler and Qingyi Freda Drechsler—authors of the March 2014 study, “The Shorting Premium and Asset Pricing Anomalies”—sought to determine if the shorting fee provided information as to the stock’s expected return. Their study covered the period January 2004 through October 2012, and included 95 percent of stocks in the CRSP database and more than 85 percent of borrowing activity in the U.S. security lending market. Following is a summary of their findings:




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