The important role played by short sellers, who by their actions keep prices efficient by preventing overpricing and the formation of price bubbles in financial markets, has received increasing academic attention in recent years. Research into the information contained in short-selling activityi 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.
Q1 2023 hedge fund letters, conferences and more
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 theory is that the high costs, the risk of unlimited losses and the resulting absence of liquidity motivated short selling make short sellers more informed than average traders.
New research
Chen Chen and Licheng Sun, authors of the April 2023 study, “Swim with Sharks: Are Short Sellers More Informed than their Competitors?,” examined the interaction between short sellers and other traders to determine who were the most informed. To measure private information (informed trading), they used the probability of informed trading (PIN) model, which estimates private information from transaction-level data from the Trade and Quote (TAQ) database and has been shown to have the ability to capture private information signals. They also decomposed the PIN into two parts: PIN following good news (PIN G) and PIN following bad news (PIN B). They sought the answers to three empirical questions:
1. Do short sellers possess superior information? If so, we would expect heavily shorted stocks to underperform lightly shorted stocks.
2. Do PIN G and/or PIN B have any predictive value? If they do, we should expect statistically significant results for informed buying but insignificant results for informed selling.
3. Are short sellers more informed than other types of informed traders (especially informed buyers)? If so, if the stocks favored by informed buyers are subject to heavily short selling and their adjusted returns are negative, it indicates short sellers are more informed and vice versa.
Read the full article here by Larry Swedroe, Advisor Perspectives.
