PEAD Archives | The Evidence-Based Investor

The role of short sellers in market efficiency

July 16, 2021 8:46 am Comments Off

By LARRY SWEDROE

There is a large body of academic research into the information contained in short-selling activity. These include the 2016 study The Shorting Premium and Asset Pricing Anomalies, the 2017 study Stock Loan Fees, Private Information, and Smart Lending, and the 2020 studies Securities Lending and Trading by Active and Passive Funds and The Loan Fee Anomaly: A Short Seller’s Best Ideas. The research demonstrates that short sellers are informed investors who are skilled at processing information. Those studies found that stocks with high shorting fees earn abnormally low returns even after accounting for the shorting fees earned from securities lending. They also help explain returns to many anomalies. Thus, loan fees provide information in the cross-section of equity returns and help keep markets efficient.

Bige Kahraman contributes to the literature on the role short sellers play in keeping markets efficient with her study Publicizing Arbitrage, published in the May 2021 issue of the Journal of Financial and Quantitative Analysis. The focus of her paper was to determine how greater public disclosure of arbitrage activity and informed trading affect price efficiency. To find the answer she exploited rule amendments in U.S. securities markets, which imposed a higher frequency of public disclosure of short positions.

She began by noting that higher public disclosure can hurt the production of information and deteriorate efficiency — arbitrageurs may lose their informational advantages by having to reveal their positions before they can be fully built up, reducing their incentives. Or higher public disclosure can be beneficial by mitigating the limits to arbitrage and diffusing arbitrageurs’ information faster.

Arbitrageurs can be hesitant to attack a mispricing because of horizon risk, the risk that the mispricing can take too long to correct so that potential profits are eroded due to accumulating transaction costs or the risk that the mispricing worsens in the short run.

Kahraman added: “Public disclosure of short-sales positions can therefore be helpful as it can allow the rest of the investing public to learn from short-sellers more promptly. Moreover, if increased public disclosure of short positions hastens the diffusion of short-sellers’ information, then short-sellers’ horizon risk would be reduced, thereby increasing short-selling activity and improving price efficiency.” She provided an empirical examination of the two views by studying the effects of amendments to rules approved by the SEC (effective September 7, 2007) that increased the frequency of short interest reporting requirements from once a month (on the 15th) to twice a month (on the 15th and at end of month).

U.S. securities exchanges publicise each stock’s total short interest, defined as the total outstanding short positions in a given stock. Prior to the amendments, investors in the U.S. received new information on short interest only after the settlement date on the 15th of each month. In the post-amendment period, investors receive additional new information on short interest after the settlement date at the end of each month.

Kahraman tested the difference in price efficiency between pre- and post-amendment periods, including the “placebo dates,” when short interest would have been publicly reported had broker-dealers been required to report short interest positions at the end-of-month in the pre-amendment period. Her main measure of price efficiency was the cumulative abnormal returns around quarterly firm earnings announcements — the post-earnings announcement drift (PEAD) anomaly, the tendency for a stock’s cumulative abnormal returns to drift in the direction of an earnings surprise for several weeks (even several months) following an earnings announcement. Her data sample was split into two periods: January 2003-September 2007 (the pre-amendment period) and September 2007-December 2012, (post-amendment period). Following is a summary of her findings:

The new disclosure regime has an important impact on a stock’s informational environment.
Information encapsulated within short interest, which contains information about future company news, was more quickly incorporated into prices, thereby increasing price efficiency.
With faster information diffusion, short seller holding periods declined by about 10 days, allowing them to both cash in their positions more quickly and take larger positions.
In the post-amendment period, earnings announcements occurring after the end-of-month short interest announcements were less of a surprise to the market. The lower price reactions were complemented by lower trading activity and lower volatility. In addition, in the post-amendment period there was on average a 7 percent reduction in the pre-earnings announcement bid-ask spread.
Relative price efficiency in the post-amendment period improved on average by a statistically significant 7 percent (mean) and 11 percent (median)—about 30 basis points in absolute terms.
The effects were larger for stocks with negative information and more pronounced for stocks with higher arbitrage risk.
There were significant price reactions on announcement days, especially for stocks with large increases in short interest—highlighting the significance that public disclosure of short interest provides to investors.
The results were robust to various tests.

Kahraman concluded that her findings “provide strong support for the hypothesis that increased public disclosure improves price efficiency”. She added that her findings “are consistent with studies which emphasize the benefits that publicizing arbitrageurs’ positions can provide. … Public disclosures can help arbitrageurs overcome the limits to arbitrage arising from horizon risk, and subsequently, public disclosures can improve price efficiency.” It’s important to note that the twice monthly short interest disclosures are not the only source of information. Institutional investors can get shorting information (such as availability and cost to borrow) from brokers and data providers. This data availability has increased since the increased disclosure requirement became effective. This may also be contributing to market efficiency.

An interesting question is: Now that we have seen how the Robinhood traders can “band together” to exploit the availability of shorting information by engaging in short squeezes — a good short position could be made untenable in the near term by a short squeeze, and thus one can be right in the long term but unable to survive until then — will Kahraman’s findings continue to hold?

Important Disclosure: The information presented here is for educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based upon third party data which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured author are their own and may not accurately reflect those of Buckingham Strategic Wealth® or Buckingham Strategic Partners®, collectively Buckingham Wealth Partners. LSR-21-93

LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.

ALSO BY LARRY SWEDROE

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The role of “active fee” in fund selection

Patient investing is hard

How to think differently about diversification

The impact of recency bias on equity markets

Passive growth makes it harder to generate alpha

PREVIOUSLY ON TEBI

Why SJP’s latest Value Assessment still doesn’t cut it

Do cryptocurrencies serve the public interest?

Genuinely bespoke portfolios are largely a myth

The investing industry is not your friend

Does the low-volatility premium actually work?

Should you invest in a dividend ETF?

Do fund managers who outperform possess genuine skill?

September 17, 2018 5:08 pm Comments Off

One of the biggest problems facing journalists like me who write about fund managers is that distinguishing between luck from skill is extremely difficult.

Some journalists write about active managers who happen to have produced a few years of decent returns as if their skill is self-evident. The brutal truth is, however, that most of the outperformance you’ll read about in the media has no statistical significance whatsoever. Over the very long term, no more funds outperform the market on a risk- and cost-adjusted basis than you would expect from random chance.

There are journalists on the other hand, the BBC’s Paul Lewis among them, who argue that all outperformance is purely down to luck. Although I very much share Paul’s scepticism about the value of active management generally, I wouldn’t go as far as denying the existence of skill altogether.

There have been several academic studies in the US — notably by Michael Jensen in 1968, Burton Malkiel in 1995 and by Barras, Scaillet and Wermers in 2010 — which have all found that outperformance is more likely to be due to luck than skill.

The best-known UK study, New Evidence on Mutual Fund Performance by David Blake, Tristan Caulfield and Christos Ioannidis, last updated in 2014, concluded that while a few “star” managers do exist, “they extract the whole of this superior performance for themselves via their fees, leaving nothing for investors”. It also found that, ex ante, winning funds are “incredibly hard to identify”. Furthermore, the researchers found, the “vast majority” of fund managers they looked at “were not simply unlucky”, but were “genuinely unskilled”.

Now a new study by two US academics, Charles Lee and Christina Zhu, has shed fresh light on this important subject. Lee and Zhu specifically analysed trades made by active managers around company earnings announcements.

It is a well-known investment anomaly that in the event of a surprising announcement — in other words, if a company announces significantly higher or lower earnings than the market had expected — it can take several weeks or even months for that new information to be fully reflected in the share price. The phenomenon is referred to by financial economists as post-earnings-announcement drift (or PEAD) and it offers active managers who are either able to predict surprising announcements or act on them fast enough an opportunity to profit.

So what was the outcome of Lee and Zhu’s research? Well, first they noticed a marked significant increase in the volume of trading by active mutual funds on the day of an announcement. More importantly, their findings showed that active managers do demonstrate skill in their ability to anticipate and act on announcements and do contribute to the price discovery process, thereby helping to keep markets efficient.

There is, however, a caveat. Lee and Zhu also found that on days when there wasn’t an earnings announcement, the trades that active managers made were not profitable. Interestingly, the researchers also observed that the PEAD effect has declined over time and that, in recent years, it’s only in the small-cap sector that active managers have been able to take advantage of it.

So what conclusions can we draw? First, if Lee and Zhu are correct, managers do exhibit some skill in anticipating and acting on earnings announcements, but that is offset by their inability to trade profitably on days when there isn’t an announcement. Furthermore, the decline in the PEAD effect appears to show that markets are becoming more efficient, making it even harder for active managers to beat the index.

The key point once again is that performance before costs is irrelevant; if managers can’t generate alpha net of fees and charges, they’re subtracting value from the investment process.

To quote the investment author Larry Swedroe, “having skill is only a necessary condition to generate alpha. The sufficient condition is having sufficient skill to overcome all costs. The evidence is clear that, on a net basis, active management remains a loser’s game.”

The existence of skill is one thing; skill that is identifiable, and worth paying for, is quite another.

EVIDENCE-BASED INVESTING FOR TRUSTEES

Are you the trustee of a UK pension fund or charitable trust? If you are, you may be interested to know that, in conjunction with RockWealth LLP, I’m running two breakfast seminars in the next few weeks on evidence-based investing from an institutional point of view.

Among the questions we’ll be asking are the following:

What does the academic evidence tell us about the efficacy of investment consultancy?

Can consultants really identify outperforming funds in advance?

Do the costs of using consultants outweigh any benefits they provide?

Why are trustees so keen on high-fee investments such as hedge funds which have provided such disappointing returns? And

For an institutional investor, what does an evidence-based investment strategy look like?

The first seminar is in Cheltenham on Wednesday 3rd October, and the second in London on Wednesday 17th October. Among the other speakers will be Charles Payne, formerly Investment Director at Fidelity, and the hedge fund manager turned indexing advocate Lars Kroijer.

Trustees of pension and investment funds of all kinds are welcome to come, and attendance is free. If you’d like to attend, simply email Sarah Horrocks at RockWealth at sarah@rock-wealth.co.uk.

The Evidence-Based Investor

Tag Archive: PEAD