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.
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:
- AMFs tended to trade on the right side of the nine anomalies – shorting overpriced stocks and buying underpriced ones.
- The average fund exhibited the ability to short sell overpriced stocks and short cover their underpriced peers.
- Short selling overpriced short-leg anomaly stocks was more profitable than buying underpriced long-leg counterparts, in the absence of shorting costs.
- The overpriced stocks sold short by AMFs generated significant negative alpha – on average, the overpriced stocks that AMFs short sold generated a statistically significant alpha of -4.73% per year (t-stat = -2.92). In addition, the overpriced stocks AMFs short sold collectively underperformed those they short covered by an average annualized alpha of -4.09% (t-stat = -2.60). And the underpriced stocks AMFs short covered on average generated positive, though statistically insignificant, alpha.
- The underpriced stocks AMFs short sold underperformed those they short covered by an average of 2.51% annually, although the difference was not statistically significant.
- AMFs’ short-side anomaly-based trading activity and profitability were more pronounced among the stocks with higher credit risk – the alpha generated by the overpriced stocks sold short by AMFs diminished with improving credit ratings. For example, these stocks generated an average annualized alpha of -7.49% (t-stat = -2.87) in the worst-rated tercile but statistically insignificant alpha of -2.81% per year (t-stat = -0.90) in the best-rated tercile.
- AMFs in aggregate had strong preferences for small-cap growth stocks with high liquidity and idiosyncratic volatility in their short-selling decisions. They also tended to cover their short positions in large-cap value stocks with low liquidity and idiosyncratic volatility – liquidity plays a significant role in the decisions of short sellers, short-selling more liquid stocks and short covering more illiquid stocks.
- The return predictability of AMFs’ short-side trades lasted up to two quarters.
- Short-selling risk was higher for stocks with a larger number of failures in the securities lending market and for stocks with higher volatility, higher trading volume and larger bid-ask spreads. AMFs’ short-side anomaly-based trading activity and profitability appeared to be more pronounced among the stocks associated with higher dynamic short-selling risk. And stocks with higher dynamic short-selling risk had lower returns.
Their findings led Gao and Wang to conclude: “The evidence implies that the return predictive power of AMFs’ short-side trades can at least partially derive from their superior ability to acquire and process public information related to firm characteristics and well-known anomalies.”
There is one more important point to cover.
Risks of shorting allow anomalies to persist
The high risks and high costs of shorting allow some inefficiencies to persist, explaining the information provided by short sellers. The recent GameStop episode, in which retail investors using social media banded together with sufficient capital to engineer a short squeeze by attacking the short positions of well-capitalized hedge funds, demonstrated just how risky shorting can be. That type of risk was one that had never been experienced and almost certainly was not expected.
Compounding the risks of shorting, as Xavier Gabaix and Ralph Koijen demonstrated in their 2021 study, “In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis,” is that markets have become less liquid and thus more inelastic. Gabaix and Koijen estimated that today $1 in cash flow results in an increase of $5 in valuation. One explanation for the reduced liquidity is the increased market share of indexing and passive investing in general. Reduced liquidity increases risks of shorting. Adding further to the risks is the now-demonstrated ability of retail investors to “gang up” against shorts. The limits to arbitrage have increased, allowing for more overpricing of “high sentiment” (typically glamour growth) stocks, making the market less efficient. That could result in more persistent overpricing on the wrong side of anomalies.
A large body of evidence demonstrates that short sellers are informed investors who play a valuable role in keeping market prices efficient—short selling leads to faster price discovery. Fund families that invest systematically have found ways to incorporate the research findings to improve returns over those of a pure index replication strategy. It seems likely this will become increasingly important, as the markets have become less liquid, increasing the limits to arbitrage and allowing for more overpricing. The evidence demonstrates that you should not own stocks with high borrowing fees. Forewarned is forearmed.
Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners.
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