The academic evidence is clear: short sales do not hurt equity prices

Fidelity Worldwide’s decision to review its securities lending program has revived the debate about whether securities lending, as it supports short selling, hurts equity prices. We find consistent evidence across years of data that this just isn’t the case. Here are the studies that show either no relationship or that a loss of short selling ability, largely from short selling bans, actually damages the market.

The most cited paper on short selling bans and market prices is “Short-Selling Bans Around the World: Evidence from the 2007-09 Crisis” by Alessandro Beber and Marco Pagano, available here. Following government short selling bans during the 2008 crisis, these professors found that “bans (i) were detrimental for liquidity, especially for stocks with small capitalization and no listed options; (ii) slowed down price discovery, especially in bear markets, and (iii) failed to support prices, except possibly for U.S. financial stocks.” In sum, no short selling hurt market quality and did almost nothing to support prices.

A slightly different paper finds that short sellers sell short on the fundamentals and are not pushing prices below where the fundamentals suggest they should be. In “Does Short-Selling Amplify Price Declines or Align Stocks with Their Fundamental Values?,” available here, authors Asher Curtis and Neil Fargher note that “while not all short positions appear to be motivated by perceptions regarding firm value, a significant concentration of short positions following price declines appear to align prices with fundamentals rather than force prices below fundamental values.”

On the fixed income side, last week the IMF came out with an announcement that the EU’s decision to ban naked short sales on sovereign debt could weaken market stability, not improve it. According to the IMF, “”The recent European ban on purchasing naked SCDS protection appears to move in the wrong direction. While the effects of the ban are hard to distinguish from the influence of other policy announcements, the prohibition may have already caused some impairment of market liquidity.” Here is a Reuters summary of the IMF report.

More generally, pretty much every international regulator and agency has said that short selling benefits market quality. We note that this is talking about short selling backed by a securities loan and not naked short selling, which is actually very damaging and undermines market integrity. The benefit of legitimate short selling is to introduce all the known information about a security at any one time. Here is IOSCO’s take on the matter from 2009.

The decisions to enact short selling bans in Europe are pretty much agreed to be driven by political sentiment, not the reality of stopping declining stock prices. SunGard did a nice analysis of Spain’s recent short selling ban and found that while prices rose during the ban, there were many other factors at stake. An ample utilization of available assets are other times did not on the other hand result in price declines. Registration is required to get the full paper.

At IMN’s 2010 Beneficial Owner Conference in the US, SunGard also presented a slide on Green Mountain Coffee that showed the company’s stock price rising as intrinsic value increased for securities lenders. The short sellers paid more and got the story wrong on that one, at least in 2010.

We also heard the question of securities loans damaging stock prices last week from a buy-side client, where a portfolio manager had asked to pull a few names from their lending program. Our response was to look at the fees each security was earning and make a determination from there. Three of the four names were GC or close to it with no utilization to speak of; we saw no harm to pull those names if there was any demand to begin with. The last name was earning over 20% annually with high utilization. We thought this should stay in the lending program as it generated good revenue. The real question is whether the portfolio manager is committed to the stock. If so, it is a keeper in both the portfolio and the lending program. If not, time to sell.

In Fidelity Worldwide’s case (we understand this to be a separate legal entity from the US Fidelity mutual funds), we can see a decision to leave lending if the funds generate insufficient revenue to justify the program. Fidelity Worldwide also mentioned a shrinkage of dividend arbitrage revenues, which we think is another real reason to leave lending.

The old argument that securities lending and hence short selling hurts market prices though does not appear justified anywhere however. The academic evidence and regulatory support argue otherwise.

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