Adam V. Reed

Stocks are special too: an analysis of the equity lending market

With a year of equity loans by a major lender, we measure the effect of actual short-selling costs and constraints on trading strategies that involve short-selling. We find the loans of initial public offering (IPOs), DotCom, large-cap, growth and low-momentum stocks to be cheap relative to the strategies’ documented profits and that investors who can short only stocks that are cheap and easy to borrow can enjoy at least some of the profits of unconstrained investors. Most IPOs are loaned on their first settlement days and throughout their first months, and the underperformance around lockup expiration is significant even for the IPOs that are cheap and easy to borrow. The effect of short-selling frictions appears strongest in merger arbitrage. Acquirers’ stock is expensive to borrow, especially when the acquirer is small, though the major influence on trading profits is not through expense but availability.

Leaning for the Tape: Evidence of Gaming Behavior in Equity Mutual Funds

We present evidence that fund managers inf late quarter-end portfolio prices with last-minute purchases of stocks already held. The magnitude of price inf lation ranges from 0.5 percent per year for large-cap funds to well over 2 percent for small-cap funds. We find that the cross section of inf lation matches the cross section of incentives from the f low0performance relation, that a surge of trading in the quarter’s last minutes coincides with a surge in equity prices, and that the inf lation is greatest for the stocks held by funds with the most incentive to inf late, controlling for the stocks’ size and performance. QUARTER-END AND ESPECIALLY YEAR-END equity mutual fund prices are abnormally high. We present strong evidence that some mutual fund managers mark up their holdings at quarter end through aggressive trading of stocks they already hold. Funds with the greatest ability and most incentive to improve their performance exhibit the largest turn-of-quarter effect. Intradaily data show a surge of transactions and transaction prices in the quarter’s last few minutes, and fund-holdings data show a larger effect in the funds with the most incentive to mark up. Considering that open-end equity funds intermediate

A Multiple Lender Approach to Understanding Supply and Search in the Equity Lending Market

3.46 trillion ~year-end 1999!, 1 this turn-of-quarter inf lation of their prices is a significant opportunity for potential sellers, and a significant hazard for everybody else. In general, open-end domestic equity mutual funds calculate their net asset values per share ~NAVs! from the closing transaction prices of their holdings.

Short Selling Risk

Using unique data from 12 lenders, we examine how equity lending fees respond to demand shocks. We find that when demand is moderate, fees are largely insensitive to demand shocks. However, at high demand levels, further increases in demand lead to significantly higher fees and the extent to which demand shocks impact fees is also related to search frictions in the loan market. Moreover, consistent with search models, we find significant dispersion in loan fees, with this dispersion increasing in loan scarcity and search frictions. Our findings imply that search frictions significantly impact short selling costs.

Can Short Restrictions Result in More Informed Short Selling? Evidence from the 2008 Regulations

Short sellers face unique risks, such as the risk that stock loans become expensive and the risk that stock loans are recalled. We show that these short selling risks affect prices among the cross-section of stocks. Stocks with more short selling risk have lower returns, less price efficiency, and less short selling.

Revealing Shorts: An Examination of Large Short Position Disclosures

We use the 2008 short selling regulations to conduct the first test of Diamond and Verrecchia’s (1987) counterintuitive prediction that short sale constraints can actually increase the information content of short sales. The emergency order made it difficult and costly for short sellers without strong broker relationships to borrow shares; borrowing fees increased by over 500%. Similarly, the short selling ban prohibited short selling in the spot market, but sophisticated traders could still short synthetically via the options market. As such, there is good reason to expect that both regulations increased the proportion of informed short sellers. Consistent with this notion, we find that the price reaction to announcements of unexpectedly high levels of short interest became more negative when the regulations were in effect. We also find that the price impact of short sales increased during the ban for affected stocks. Our results confirm the counterintuitive and previously untested prediction that short selling restrictions may actually increase the information content of short selling.

The Limits to Dividend Arbitrage: Implications for Cross Border Investment

By 2012, all European Union countries began requiring the disclosure of large short positions. This regime change reduced short interest, bid-ask spreads, and the informativeness of prices. After specific disclosures, short-run abnormal returns are insignificantly negative, but 90-day cumulative abnormal returns are –5.23%. We find disclosures are likely to be followed by other disclosures, especially when the initial discloser is large or centrally located, but there is no subsequent increase in short interest, and prices do not subsequently reverse. These results indicate that large short sellers are well-informed, and that disclosures are not being used to coordinate manipulative attacks.

Shorting in Broad Daylight: Short Sales and Venue Choice

The economic significance of the tax on cross-border dividends depends on the limits to dividend arbitrage. In the case of Canadian payments to the U.S. we observe these limits exactly because we see the actual pricing of the dividend-arbitrage transactions. These transactions recover only some withholding, so that Canadian and non-tax U.S. accounts perceive different expected returns from Canadian stocks, where the difference increases with dividend yield. The resulting difference in expected utility of wealth is small but the difference in efficient portfolio weights is potentially large and increasing in yield, and the actual difference between Canadian and U.S. holdings of Canadian stocks is large and increasing in yield. Governments may thus take advantage of robust financial markets to boost domestic governance of domestic firms at a low utility cost, though this may be more preferable for zero-dividend firms, whose governance moves abroad.

Short Sales Constraints and the Diversification Puzzle

Using a novel database on venue short sales and market design characteristics, we ask: Where do short sellers exploit their information advantage? Consistent with the prediction of Zhu (2014), we find that exchange short sales comprise a larger proportion of trading and are more informative about future prices than dark pool short sales, particularly when there is greater competition among short sellers to trade and in the presence of short-lived information. When examining market design characteristics, we find that dark pools offering volume weighted average price crossing attract more short sales while those offering block trading attract fewer short sales.

How are Shorts Informed? Short Sellers, News, and Information Processing

Building on Millers (1977) short sales constraints insight, we construct a model showing that investors should disagree less about the valuation of a conglomerate than about the valuations of its individual divisions. Disagreement, combined with short sales constraints, increases asset prices and thereby implies a conglomerate discount. The model provides a wide variety of empirically testable implications about the incidence and size of the conglomerate discount. We test several of these predictions, and find that (i) conglomerates face fewer short sales constraints and have less dispersion of opinion than focused firms, and (ii) the conglomerate discount increases with short sales constraints and decreases with differences of opinion. While we are unable to fully explain the conglomerate discount through proxies of short sales constraints and differences of opinion, we find that they reduce its magnitude by between 50-70% using matched sample estimates.