Swedroe: Shorting's Costly Complexities

In addition, temporary short-selling bans have been discovered to impede pricing efficiency. Without short-sellers, equity prices can become overvalued because only the optimists would be expressing their opinions on valuations.

The research has also found that, even in the presence of short-sellers, anomalies (mispricings) continue to exist because stocks can remain overvalued. Academic research has tried to explain why these anomalies continue to persist.

The Persistence Of Overpriced Stocks

Among the explanations offered by researchers 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.
• 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 that 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 the supply of equities available from institutional investors is low. Overvalued stocks tend to be overweighted by individual investors and underweighted by institutional investors, who are the lenders of shares. The largest anomalies tend to occur in small stocks, which are costly to trade in large quantity—both long and (especially) short. Also, the volume of shares available to borrow is limited because they tend to be owned by individual investors, and borrowing costs are often high.

Two Important Questions

The availability of shares to borrow in order to short a stock served as the focus of a November 2013 study, “In Short Supply: Equity Overvaluation and Short Selling,” by Messod Daniel Beneish, Charles M.C. Lee and Craig Nichols. Their study, which covers the period from July 2004 through October 2011, focused on answering two questions:

• What prevents short-sellers and other market participants from fully eliminating the observed negative association between short interest and future returns?
• To what extent are the negative returns to the short leg of other market pricing anomalies due to frictions in the market for short-selling?

While much of the prior research had focused on what is called the short interest ratio (SIR), which is defined as the ratio of total shares shorted to total shares outstanding.

The authors noted that:

“This measure tends to mask the true importance of supply. The total shares shorted in the numerator is an equilibrium result that reflects both supply and demand. Thus, a firm’s open short interest may be low either because (1) few investors have negative views, or (2) the supply of lendable shares is limited.”

How Many Shares Are Lendable?

The authors also found that the supply of lendable shares is crucial in answering these questions.

The data on lendable shares was provided by Data Explorers (DXL). DXL provided a measure of supply, Beneficial Owner Inventory Quantity (BOIQ), which the authors expressed as a percentage of shares outstanding. BOIQ reflects the total pool of shares held by DXL lenders and made available to borrow. BOIQ averaged 17.2 percent of shares outstanding for sample firms. DXL participants included more than 100 of the largest institutions in the world and, collectively, the consortium represents the largest share lender in the world.

The following is a summary of the authors’ findings:

• The total supply of lendable shares affects the size and volume of short positions that can be taken at low cost.
• When the supply of shares available for lending is a binding constraint, the extent to which the negative views of sellers can be impounded into price will be limited, and mispricing exists. 
• Even for easy-to-borrow stocks, the average number of easily lendable shares is typically only 20 percent of shares outstanding. In other words, a SIR of 10 percent could represent a “utilization” of up to 50 percent of the available supply for some stocks, or nearly 100 percent for others, highlighting the problems inherent in SIR as a measure of either pessimism or constraints.
• A stock’s daily cost of borrowing score is positively correlated with SIR, but negatively correlated with the supply of shares available to be borrowed. Stocks with plenty of supply available to be borrowed have low costs of borrowing (less than 1 percent). These stocks account for about 86 percent of equities and don’t exhibit pricing anomalies because the negative opinions are embeddable in prices. However, the hard-to-borrow stocks, which account for the remaining 14 percent of stocks, have high costs of borrowing and exhibit abnormally low returns, even after accounting for the high costs, because the negative opinions cannot be fully expressed. The stocks with high borrowing costs are called “specials.”
• When borrowing constraints aren’t binding, high short interest ratios aren’t associated with future returns. In other words, it’s a stock’s specialness rather than its SIR that predicts negative returns. And among special stocks, the lowest returns accrue to stocks with the lowest supply.

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.