“First, we find that analysts and short sellers use publicly available information differently. Analysts over-recommend stocks with high growth, high accruals, and low book-to-market ratios, even though prior research shows these characteristics are negatively related to future returns. In contrast, short sellers incorporate into their investment decisions the future return implications of all eleven accounting and market variables considered in this study.

“Second, we find that short interest provides information about future returns beyond that provided in the eleven items of information that prior research shows to be predictive of future returns. Analysts’ recommendations also provide incremental information, but a negative coefficient suggests trading against the analysts.

“Third, based on these results, we show that a highly profitable trading strategy is one where investors trade with the short sellers when the short interest signal strongly conflicts with the consensus analyst recommendation. In fact, the value of short interest in choosing stocks to buy or sell is greater when conditioned on a conflicting consensus recommendation than when used by itself to trade stocks.

“An important implication of our study is that regulations that restrict or increase the cost of short selling run the risk of limiting a potentially important source of information for investors about future equity values.”

He writes, “Fortunately, the anti-short tide seems to be turning a little. As the market bottomed and climbed in 2009, the traditional role of shorts as a stabilizing force became more apparent—after all, they eventually have to buy back the shares they borrow and sell. The crisis also reminded investors and regulators that shorts are often the most effective corporate watchdogs.

“A recently published study by researchers at the University of Chicago and the University of Toronto examined 216 corporate fraud cases between 1996 and 2004. Shorts uncovered 14.5% of those frauds, not far behind the 17% that were exposed by whistleblowers within companies. And what about the SEC? It uncovered just 6.6% of the frauds.”

That study, “Who Blows the Whistle on Corporate Fraud?” was written by University of Chicago professors Adair Morse and Luigi Zingales and Rotman School of Management Professor Alexander Dyck.

Another study ( “Short Sellers and Financial Misconduct” ) published by researchers Jonathan M. Karpoff at the University of Washington and Xiaoxia Lou at the University of Delaware found that short sellers:
• Accelerate the average time to discovery of corporate misconduct (from 26 to 18 months).
• Dampen the inflation of a company’s share prices during the period of financial fraud.
• Do not exacerbate the inevitable share price drops when a firm’s fraud is revealed publicly.
• Predict which firms will be caught misrepresenting their finances.

“At an Aug. 13 meeting, officials from government supervision departments and funds companies discussed a variety of technical details surrounding securities lending.

“Meeting participants said discussions highlighted whether funds should participate in the securities lending business, when stakeholder meetings might be needed, how to price securities packages, and whether capital raised through securities financing should be re-invested.

“Margin lending has been undergoing tests under a government-backed pilot project since March 31, when margin and securities lending products were allowed on a limited basis. The mechanism now under discussion could open a door to full market participation by next year.”

1. No strong evidence that SS led to falling prices. “Evidence suggest that most of the adverse market movement in the current crisis can be attributed to fundamental factors and to uncertainty due to partial or inadequate disclosures.”

2. Bans harmed markets.

“In Europe, various market authorities banned (naked) short sales of financial stocks in September 2008 but this did relatively little to support the targeted institutions’ underlying stock prices, while liquidity dropped and volatility rose substantially. Annex 3 suggests that market efficiency and quality in fact deteriorated substantially following the introduction of the various bans. Moreover, many of the financial institutions subject to short sales bans also are cross-listed, which created legal and territoriality issues as regards enforcement.”

3. Effective supervision needed. New rules will be ineffective if there isn’t effective regulation that enhances price discovery while preventing price distortions.

4. Pan-European disclosure with more disclosures that do not overburden market participants.

“Market efficiency and quality in fact deteriorated substantially following the introduction” of short-selling bans in Germany and other European Union countries, said in a report published yesterday and posted on the fund’s website.

The ban by Chancellor Angela Merkel’s government, issued by the BaFin regulator overnight on May 19, “did relatively little to support the targeted institutions’ underlying stock prices, while liquidity dropped and volatility rose substantially,” it said

Download PDF

In his essay (“EU Hedge Fund Rules May Hurt Investors,” July 28, Business Times), Teo outlines three areas where EU investors will suffer.

First, the new regulations will “price out” many small hedge funds. “Research has shown that smaller and newer funds tend to deliver higher returns relative to their larger and older competitors, even after adjusting for risk. These emerging fund managers are better poised to take advantage of market opportunities than their less nimble counterparts.”

Second, “my research on Asia-focused funds indicates that, by taking advantage of local information, nearby funds that are located close to their investment markets outperform distant funds. . . .. The new directive may rob EU investors of the option to invest in funds that are located geographically close to their investment markets, for example, Asia-focused funds based in Asia.”

Third, “the new rulings will ramp up co-mingling risk. If the new regulations succeed in walling off non-EU based funds from EU investors, EU investors may end up investing alongside other EU investors only. Because shocks to the wealth of EU investors are correlated, this heightens the risk that a significant proportion of investors will redeem at the same time.”