In Short Supply: Short-­‐seller and Stock Returns Daniel Beneish Charles Lee Craig Nichols 1 The Big Picture Understanding the Role of Short Sellers in Equity Pricing & Stock Returns Predic:on 1.  Short-­‐sellers are important informa3on intermediaries –  Superior informa?on processers –  Their ac?ons improve overall pricing efficiency (intraday; event-­‐
related; country-­‐level) –  Short-­‐sale constraints impede pricing efficiency (e.g. in banned stocks) 2.  What real-­‐3me constraints do they face? –  Borrowing costs = f(demand dynamics and supply constraints) –  What implica?ons do these have for future stock returns? –  For the design and regula?on of the equity loan market? 2 The Equity Loan Market The “Retail” Market Source: Interac7ve Brokers (www.interac7vebrokers.com) The “Wholesale” Market $1+ Trillion in Open Short Interest; but no centralized quote system, no consolidated market clearing mechanism 3 Our Focus How (and when) does the supply of lendable shares maBer? (Quite a lot, actually) –  Earlier studies used ins?tu?onal ownership as a proxy e.g., Chen, Hong and Stein (2002), Asquith, Parthak and RiYer (2005), Nagel (2005) and Hirshleifer, Teoh and Yu (2011). –  Others used short-­‐selling data from a single lender e.g., D’Avolio 2002; Geczy, Musto, and Reed 2002; and Boehme, Danielson, and Sorescu 2006 –  Joint equilibrium analysis Blocher, Reed, and Van Wesep (2013); Kolasinski, Reed, and Riggenberg (2013): supply constraint is crucial in explaining the impact of demand shocks on lending fees & equity returns. 4 Our Approach We use a comprehensive dataset to examine the role of supply constraints for a wide cross-­‐sec:on of stocks. •  Markit Data Explorer (DXL)… –  Consor?um of over 100 ins?tu?ons –  Covers over 90% of US equi?es by count and market value –  Captures at least 70% of all shor?ng ac?vity in the US –  Includes a daily cost of borrowing measure (DCBS) –  A measure of consolidated supply (BOIQ) •  …for the longest period examined to date, spanning 114 months (June 2004 to November 2013) 5 Research Ques?ons How (and when) does the supply of lendable shares maBer? (
Quite a lot, actually) •  Characteris3cs of short supply: Describe market-­‐wide availability of lendable shares; discuss its implica?ons for the “short interest ra?o” (SIR) •  Consequences of short supply: Prior studies show that hard-­‐to-­‐borrow (“special”) stocks earn lower subsequent returns… how do supply and demand metrics affect future returns aoer condi7oning on specialness. •  Determinants of short supply: What cross-­‐sec?onal characteris?cs are associated with higher borrowing costs and lower supply? In par?cular, we are interested in how various accoun?ng characteris?cs (associated in prior studies with pricing anomaly) affect lending costs and supply constraints. 6 Overview of Results How much does supply of lendable shares maQer? (Quite a lot, actually) –  Describe the level and cross-­‐sec?onal varia?on of easily lendable supply •  Supply levels are much lower than total shares outstanding •  Supply constraints result in drama?c increases in lending costs •  SIR is a noisy measure of both demand and supply constraints –  Examine the consequences of short supply •  For unconstrained stocks, demand is main predictor of returns. •  For constrained stocks, supply is main predictor of returns •  The short-­‐side of various trading strategies only profitable for “special” stocks. –  Examine the determinants of lendable supply •  Both expected borrowing costs and available supply are impacted by various firm characteris?cs (vola?lity; default risk; low-­‐price; ins?tu?onal ownership) •  Both borrow costs and supply are sensi?ve to the accoun?ng characteris?cs that are commonly associated with pricing anomalies (so supply is least available when firms are most aYrac?ve to short-­‐sellers). 7 Detailed Results 8 Table 1, Panel A. Coverage by DXL Month t+1 Size-­‐
adjusted Returns By the end of our sample period, DXL covers over 90% of US equi?es by count and market value, but the sample is ?lted toward larger firms SIR = (# shorted /
total outstanding) “borrow cost” “Supply” “Demand” 9 Table 1, Panel B. Describing key variables •  Average open short interest is 5% of outstanding share. •  TDQ, DXL’s most comprehensive measure of shares borrowed, averages 70% of market-­‐wide borrowings. •  BOLQ is shares borrowed by DXL borrowers from DXL lenders. 10 Table 1, Panel B. Describing key variables •  BOIQ: on average firms have 17% of shares outstanding in easily lendable inventory. •  U?liza?on of this inventory averages 21.5%. Because we use BOLQ, this is a lower bound. 11 Observa?ons and Fees by DCBS Sample is dominated by low cost firms, but borrow costs rise sharply for the set of constrained stocks Key Result: Borrow costs rise sharply with DCBS “GC” 85.7% of observa?ons “Special” 14.3% of observa?ons 12 Table 1, Panel C. Correla?ons “supply” •  Consistent with prior studies, both SIR and Special are nega?vely correlated with future returns •  Supply (BOIQ) is posi?vely correlated with demand measures (SIR, TDQ, BOLQ) but nega?vely correlated with constraint measures (DCBS, Special) •  Several other DXL variables have predic?ve power for future returns; but the pairwise correla?on of Supply with future returns is not significant. 13 Table 2, Panel A. Key variables by DCBS •  Rebate = Interest on Cash Collateral – Loan Fee •  Median loan fee for DCBS=10 firms = 46.15% annualized •  DXL covers ~70% of all short sales, across all DCBS groupings 14 Market-­‐wide inventory •  BOLQ reflects shares borrowed by DXL borrowers from DXL lenders. BOLQ thus reflects the minimum number of shares that could be borrowed from available inventory. •  BOLQ averages 55% of SIR (DXL loans/market-­‐wide loans is, on average, 0.55). •  In other words, a minimum of 55% of all the borrowed shares in the U.S. market is coming from an inventory represen?ng 17% of shares outstanding (BOIQ). •  We therefore refer to BOIQ as the supply of easily lendable shares. 15 Figure 2, Demand and Supply by DCBS Supply SIR Demand rises and supply plummets as borrowing costs rise Going from DCBS 1 to 10, SIR is higher by 6% of S/O but BOIQ is lower by 13% of S/O Demand 16 Figure 3. BOLQ and U?liza?on by DCBS DCBS is strongly related to shares borrowed as a percent of lendable shares (i.e., U?liza?on) Ul?liza?on (BOLQ/BOIQ) Demand (BOLQ) But DCBS is rela?vely insensi?ve to shares borrowed as a percent of S/O (i.e., BOLQ) It is “supply” that drives the DCBS rankings. 17 Measuring Short Interest The most common metric used in prior research to measure short-­‐selling: Open Short Interest, or SIR (# Shorted / # Outstanding) –  Typically reported monthly or semi-­‐monthly –  Prior studies show low SIR => higher returns •  Typical interpreta3on: SIR reflects short-­‐sale demand –  Problem: SIR could be low either because •  Short-­‐sellers are not interested (“low demand”) •  Short-­‐sellers are constrained (“low supply”) 18 The Case of GPRO (GoPro) •
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IPO June 2014 at $24; up 30% on Day 1 Gained another 100+% since then Currently (as if Oct 13, 2014) at $76.67 This represents a 9.66B market cap 19 The Case of GPRO (GoPro) •  “Currently investors are willing to pay close to 100% (annually) of the value in order to borrow shares,” Mr. Laird said. •  “…the percentage of GoPro shares on loan — a proxy for short-­‐
selling ac?vity — isn’t wildly outside the norm. As of Wednesday, it stood at about 2.5% of shares outstanding.”
20 Figure 4: Sort by Short-­‐interest (SIR) Deciles High (low) SIR firms are commonly viewed as being in high (low) demand by short-­‐
sellers. Percent Special and Lendable Inventory by Short Interest Ratio Decile
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For many low SIR firms, the “supply” of lendable inventory is actually quite low (i.e., they are not low demand firm). Lendable inventory
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Percent Special
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Short Interest Ratio Decile
Rank stocks into SIR Deciles 9
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But note that “% Special” forms a U-­‐shape in SIR: Both “high SIR” firms and “low SIR” firms have a high percentage of “special” (supply constrained) stocks. 21 Our data allow us to examine market-­‐wide supply GoPro has a typical short interest, but other “special” stocks in the same SIR decile also have extremely low supply Only 10% of stocks in this SIR decile are constrained Supply of lendable shares is a key difference between constrained and unconstrained stocks But the typical constrained stock in this decile has about 4% of shares available GoPro’s SIR places it here 22 Table 2, Panel B. Firm characteris?cs by DCBS The typical constrained stock is smaller firm with a lower share price, higher share turnover, nega?ve recent price momentum, and glamour (low B/M) characteris?cs 23 Table 2, Panel B. Firm characteris?cs by DCBS No?ce that the most constrained stocks generate annualized returns of around -­‐54%. But recall the borrowing costs for these stocks average an annualized 48% of their value (from Panel A). 24 Table 2, Panel C. Explaining borrowing costs with demand and supply Key Result: Supply explains more of the varia?on in borrowing costs than demand Regress DCBS on BOIQ & BOLQ: As expected borrowing costs are posi?vely related to supply and nega?vely related to demand. Combined, they explain 20.9% of the varia?on But taken alone, demand (BOLQ) explains only 1%, while Supply (BOIQ) explains 13% of the varia?on 25 Rela?onship to prior work 1. On supply and constraints… –  Prior research shows that demand maYers for constraints, but has been unable to directly examine the role of supply. –  We show that supply maYers too. In fact, supply explains 13% of the varia?on in DCBS compared to only 1% for demand. 2. On supply and returns… –  Prior work shows that constrained (“special”) stocks underperform. –  We show the importance of examining the role of supply and demand condi7onal on specialness. –  As a group, constrained stocks have less supply than GC stocks. –  For constrained stocks, the lower the supply, the worse the returns. –  This suggests that the lendable supply is the main constraints that prevents nega?ve views from being fully impounded into price. Key: Need to Understand the Role of Supply & Demand, condi:onal on “Specialness” (Special vs. GC) 26 Table 3. Returns, borrow costs, and supply by SIR decile Low SIR predicts posi?ve returns and high SIR predicts nega?ve returns 27 Table 3. Returns, borrow costs, and supply by SIR decile But the posi?ve returns to SIR are only in GC stocks (“demand”). The nega?ve returns are in special stocks (“supply”). SIR is predic:ng returns among “Special” and “GC” stocks for different reasons 28 Table 4, Panel A. Regressions of returns on short sell variables •  Demand measures are strong predictors of returns •  Supply does not predict returns for the full sample •  U?liza?on subsumes SIR 29 Table 4, Panel B. Condi?oning on Special •  Informa?on in short sell measures depends on special status •  Note BOIQ is irrelevant for GC stocks; and it predicts returns for Special stocks with the wrong sign 30 Table 4, Panel C. Supply and Demand condi?oned on special Key Result: Controlling for both Demand & Specialness, future returns are increasing in supply for Special stocks. Things make sense once we use a piece-­‐wise linear model that includes both supply and demand: BOIQ flips sign for special stocks aoer controlling for both demand and special status. 31 Table 5, Panel A. Returns to GC stocks Key Result: Demand predicts returns to GC stocks “The Unconstrained Case” For GC Stocks: Sort first by U?liza?on, then by BOLQ (demand) 32 Table 5, Panel B. Returns to special stocks Key Result: Supply predicts returns for Special stocks; but Demand (BOLQ) now has the wrong sign! “The Constrained Case” For Special Stocks: Sort first on U?liza?on, then on Supply (BOIQ). 33 Summary of results so far… •  DXL data seem to capture market-­‐wide short-­‐selling condi3ons –  Borrow costs rise sharply with DCBS. –  The majority of borrowed shares come from the DXL inventory. –  Constrained stocks (based on DCBS) underperform. •  Supplies are limited –
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Typical stock has 17% of shares in easily lendable form. Constrained stocks have less than 10% of shares easily available. Supply explains more of the varia?on in borrow costs than demand. Some stocks have low SIR because of low supply. •  Both supply and demand maQer, but at different 3mes –  For GC stocks, only demand maYers. –  But for constrained stocks, supply predicts returns. 34 On Pricing Anomalies What about other market pricing anomalies? –  Prior research examines hedge returns or the spread in returns across por~olios sorted on accoun?ng characteris?cs, and commonly finds half or more of the returns stemming from the short side. –  We show that: •  The short-­‐side returns are only generated by constrained (“Special”) stocks. •  In addi?on, for the stocks iden?fied by the short-­‐side of these strategies, we show constrained stocks have much less supply, yet similar demand, rela?ve to the unconstrained stocks. –  Thus, we provide direct evidence that it is the limited supply of lendable inventory which drives the nega?ve future returns associated with these strategies. 35 Table 6, Panel A. Short side returns •  No3ce that not all short-­‐side stocks are constrained. •  But significant short-­‐side returns are concentrated in Special stocks. GC stocks on the short side don’t underperform. 36 Table 6, Panel B. Aoer high sen?ment Returns are stronger a]er high sen3ment periods (SYY(2012)), but s3ll primarily in Special stocks 37 Table 6, Panel C. Short side supply BOIQ Key Result: Special stocks have much lower BOIQ. Specials stocks on the short-­‐side of these strategies have less than half the supply of their GC counterparts 38 Table 6, Panel D. Short side demand BOLQ Key Result: Limited supply appears to be the key constraint But…Special and GC stocks don’t differ in demand (BOLQ) 39 What shapes supply? •  Borrow costs –  Jointly determined with supply, 2SLS •  Market characteris3cs –  D’Avolio (2002): Smaller, lower-­‐priced, higher turnover, lower ins?tu?onal ownership, lower B/M –  Add Return vola?lity (Mashruwala et al. 2006) •  Accoun3ng characteris3cs –  Same characteris?cs associated with overvalua?on from prior anomalies literature –  Do lenders (suppliers of readily lendable inventory) avoid overvalued firms with weak fundamentals? 40 Table 7. •  1st stage model •  Borrow costs are higher for: small, high turnover, high vola?lity, low-­‐priced, low B/M firms, with nega?ve recent price momentum & low inst. ownership •  Generally, borrow costs are also higher if the stock has weak fundamentals or signs of overvalua?on 41 Table 8. Explaining supply •  2nd stage model •  DepVar: BOIQ –  Borrow costs •  Supply is increasing in expected borrow costs •  Sign flips when we use the instrument (DCBS_OLS) –  Market characteris?cs •  S?ll have some explanatory power aoer controlling for expected borrow costs. •  Larger, lower turnover, higher priced, higher B/M, higher OI firms have greater supply •  Also when arb risk is high (based on higher RetVol), supply is low 42 Table 8. Explaining supply •  For stocks with weak fundamentals or signs of overvalua?on, supply is lower, even aoer controlling for expected borrowing costs. Key Result: Accoun?ng characteris?cs are associated with supply such that shares are least available when they are most aYrac?ve to short sellers. 43 Table 8, other specifica?ons 44 Determinants of costs & supply Summary of New Results from these Tests… –  The accoun?ng characteris?cs that prior literature associate with overvalua?on are also associated with higher borrowing costs and the lower supply of shares. –  This suggests that both short sellers and ins?tu?onal lenders are paying aYen?on to these accoun?ng characteris?cs. –  These results are consistent with the variables being viewed as indicators of overvalua?on, as lenders seem more reluctant to hold the stocks on the short-­‐side of the strategies. –  But this also means the lendable shares are least available when they are most aYrac?ve to short-­‐sellers. 45 Overview of Our Results How much does supply of lendable shares maQer? (Quite a lot, actually) –  Describe the level and cross-­‐sec?onal varia?on of easily lendable supply •  Supply levels are much lower than total shares outstanding •  Supply constraints result in drama?c increases in lending costs •  SIR is a noisy measure of both demand and supply constraints –  Examine the consequences of short supply •  For unconstrained stocks, demand is main predictor of returns. •  For constrained stocks, supply is main predictor of returns •  The short-­‐side of various trading strategies only profitable for “special” stocks. –  Examine the determinants of lendable supply •  Both expected borrowing costs and available supply are impacted by various firm characteris?cs (vola?lity; default risk; low-­‐price; ins?tu?onal ownership) •  Both borrow costs and supply are sensi?ve to the accoun?ng characteris?cs that are commonly associated with pricing anomalies (so supply is least available when firms are most aYrac?ve to short-­‐sellers). 46 Big Picture Implica?ons What have we learned from this exercise? –  Market Efficiency: short-­‐side supply is ooen binding •  Even in U.S., short-­‐selling supply constraints ooen impede info arbitrage •  These constraints are a primary reason for apparent overvalua?on •  Although equity prices may be inflated, they can be difficult to exploit –  Returns Predic3on: crucial to condi?on on “specialness” •  The usefulness of various DXL variables (DCBS, Supply, Demand, and Ul?liza?on) are all condi?onal on whether the supply is binding. •  When supply is binding, DCBS-­‐Supply-­‐Demand all move in lock-­‐step; when supply is non-­‐binding, demand is key (and SIR is s?ll useful) –  Accoun3ng Characteris3cs: impact both pricing & availability •  Both borrow costs and supply in the loan market are sensi?ve to the accoun?ng characteris?cs that are commonly associated with overvalua?on. 47 Big Picture Implica?ons A Joint Equilibrium Framework –  Pricing efficiency in the equity market is a part of a joint equilibrium outcome (Blocher et al. (2013)) –  Two markets are involved: •  The market for underlying stocks (the equity market) •  The market for informa?on (supply and demand in the market for informa?onal arbitrage on these stocks) –  Market clearing (supply=demand in both): •  If we focus only on the stock market, we would observe apparent pricing “anomalies”; the root cause of these anomalies are found in the costs and constraints inherent in the market for informa?onal arbitrage. 48 Other Implica?ons For investors… –  A number of short selling variables are strong predictors of returns, but they have to be interpreted in the context of supply constraints. –  When constrained, supply and borrowing costs predict returns. –  When unconstrained by supply, measures of demand predict returns. –  Investors should be wary of the trading profits documented in prior studies; returns to stocks on the short side are likely unavailable. For regulators… –  We show surprisingly liYle available supply, even in highly liquid markets such as the US. –  When supply constraints bind, equity prices are typically too high. –  To the extent supply can be shaped by regula?on, our study may have implica?ons for policy makers. 49 Thank You! 50