A Closer Look At Returns
The authors hypothesized that “if the apparent overvaluation identified by these strategies persists because of short-sale constraints, the returns to the short side should be concentrated in special stocks.”
Their results support this prediction. The authors found that negative short-side returns are concentrated in the special stocks, while other stocks (referred to as general collateral stocks) don’t underperform their risk benchmark.
They wrote: “Supply rather than demand seems to be the key difference between special and general collateral status among short side stocks. These findings strongly point to limits in the supply of available shares in the security-lending market as the source of the lower returns on the short side of these anomalies.”
For example, they found that “for general collateral stocks utilization rates average approximately 20 percent, whereas special stocks average approximately 50 percent. The most costly stocks to borrow have utilization averaging 77.8 percent.” The authors continue, explaining that “although this suggests ample remaining inventory, lenders need a cushion of reserve inventory.”
Against Market Sentiment
Interestingly, the authors also concluded that short-sellers tend to trade against high market sentiment, and that negative returns following high-sentiment periods are concentrated in the constrained stocks where limited supply is available for borrowing.
The authors found that: “A surprisingly small proportion of the shares outstanding is available for lending at any time, even in a market as liquid as the U.S. Moreover, when the shortage in supply is binding, equilibrium prices in the equity market are too high.” This result shouldn’t be a surprise, because it’s long been known.
In the September 1977 issue of The Journal of Finance, Edward Miller argued that: “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.”
Both Bridgeway and Dimensional Fund Advisors account for short fees when considering whether to include stocks in their list of those eligible for purchase. (Full disclosure: My firm, Buckingham, recommends Dimensional and Bridgeway funds in constructing client portfolios.)
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.
Additional Trading Costs
However, if you wanted to be very aggressive and sell the stocks with high rebate rates that you currently hold to avoid underperformance, you would not only forgo the 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 benefits from avoiding what is estimated to be about 17 basis points of underperformance per month would be worth the round-trip trading costs, especially since high-shorting-cost stocks tend to be small-caps, which have large bid/offer spreads. You would be demanding liquidity when selling.
In addition, Itamar Drechsler and Qingyi Freda Drechsler—authors of the March 2014 study, “The Shorting Premium and Asset Pricing Anomalies”—found that about a quarter of the “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 150 independent registered investment advisors throughout the country.