New Evidence that Short Sellers Correct Overpriced Stocks

New research confirms the valuable role that short sellers play in correcting the valuations of overpriced stocks.

The importance of the role of short sellers has gained increased attention from academic researchers in recent years. Short sellers help keep market prices efficient by preventing overpricing and the formation of price bubbles in financial markets. In an efficient market, capital is allocated appropriately and economically. If short sellers were inhibited from expressing their views on valuations, securities prices could become overvalued and excess capital would be allocated to those firms. Limits to arbitrage, including the risks of unlimited losses when selling short, the high costs of shorting (borrowing fees can be high), and regulations that prohibit some institutions from shorting, allow anomalies to persist. And the empirical research finds that market anomalies tend to derive their profitability mainly from short selling overpriced stocks rather than buying underpriced counterparts – it’s simpler and less risky (losses are not unlimited and there are no borrowing fees) to correct underpricing.

Research into the information contained in short-selling activity have included the 2016 study, “The Shorting Premium and Asset Pricing Anomalies,” the 2017 study, “Smart Equity Lending, Stock Loan Fees, and Private Information,” the 2020 studies, “Securities Lending and Trading by Active and Passive Funds” and “The Loan Fee Anomaly: A Short Seller’s Best Ideas,” the 2021 studies, “Pessimistic Target Prices by Short Sellers” and “Can Shorts Predict Returns? A Global Perspective,” and the 2022 study, “Anomalies and Their Short-Sale Costs.” That literature has consistently found that short sellers are informed investors who are skilled at processing information (though they tend to be too pessimistic). That is evidenced by the findings that stocks with high shorting fees earn abnormally low returns even after accounting for the shorting fees earned from securities lending. Thus, loan fees provide information in the cross-section of equity returns.

Interestingly, while retail investors are considered naive traders, the authors of the 2020 study, “Smart Retail Traders, Short Sellers, and Stock Returns,” found that retail short sellers are informed traders who profitably exploit public information when it is negative. The hypothesis is that the high costs and the risk of unlimited losses, and the resulting absence of liquidity-motivated short selling, make short sellers more informed than average traders.

Latest research

Xin Gao and Ying Wang contribute to the literature with their study, “Mining the Short Side: Institutional Investors and Stock Market Anomalies,” published in the February 2023 issue of the Journal of Financial and Quantitative Analysis, in which they examined the short-selling behavior of so-called alternative mutual funds (AMFs) in regard to nine well-documented stock market anomalies (total accruals, asset growth, gross profitability, investment-to-assets, momentum, net operating assets, net stock issuance, Ohlson’s O-score and return on assets). While most mutual funds are long only, AMFs (commonly referred to as “hedged mutual funds”) can use hedge fund-like strategies such as short selling. And unlike hedge funds, they are subject to the same rules as mutual funds and thus are required to report their holdings to the SEC – providing the authors with access to the data. According to the 2020 Investment Company Fact Book, the total number of AMFs increased from 180 to 469, and the total assets under management increased from $41 billion to $189 billion over the period 2007-2019. Their data sample was the actual short positions of a sample of U.S. equity-focused AMFs from Morningstar over the period 2002-2019. Here is a summary of their key findings: