As I recently discussed, the academic literature shows that short-sellers, while often demonized, play an important role in captal markets. For example, short-sale constraints prevent pessimistic opinions from being fully reflected in stock prices, allowing optimistic investors to drive price above their intrinsic value.
Studies have demonstrated that short-sellers are able to anticipate the public revelation that a company has misstated its financial statements and can predict negative earnings surprises, analyst downgrades and other negative company news. Furthermore, the research has found that expensive-to-short stocks (where borrowing fees are high) have low subsequent returns.
This is valuable information that even passively managed, long-only funds can put to use, as long as such funds aren’t forced to adhere to a pure indexing strategy where the sole goal is to minimize tracking error against the benchmark index.
The full article is available here.