Academic journal article Boston University Law Review

Institutional Investors as Short Sellers?

Academic journal article Boston University Law Review

Institutional Investors as Short Sellers?

Article excerpt

INTRODUCTION

Short selling1 accounts for roughly one quarter of all U.S. stock market trading.2 Yet institutional investors are largely absent from this important part of the market.3 We ask why. We also explore how social welfare might be improved if institutional investors become more involved in short selling.

Specifically, we suggest that institutions incorporate short selling into their strategies, not necessarily by taking net-short positions, but instead by combining leveraged long equity index positions with smaller actively managed short portfolios. For example, an institution with $100 million under management might buy $110 million of an equity index and also hold $10 million of short positions. To the extent institutions continue to engage directly or indirectly in active management-a strategy we recognize is controversial- we suggest that they consider shifting the active component of their strategy away from exclusively long positions and instead in the direction of new short positions. Rather than focusing exclusively on which stocks are likely to outperform the market, they could also focus more on the stocks that will not.

The core of our argument is that institutional investors obtain negative information about companies and markets, but that this information does not become fully reflected in market prices. Our argument depends on two assumptions, both of which we explore in detail. First, we assume that there are a variety of reasons, both behavioral and regulatory, why different categories of institutional investors do not engage in short selling even when it could be financially beneficial for them to do so. Second, we assume that institutional investor reluctance to engage in short selling impacts market prices. As described below, various evidence and arguments support both of these assumptions.

As an illustrative example, consider a manager of an actively traded mutual fund who regularly obtains a range of information about different companies. It is straightforward for the manager to create a new long position when she receives positive information: she simply buys stock. Likewise, it would not be unusual for the manager to sell an existing position based on negative information. But if the manager goes one step further, and suggests selling short a company's shares based on negative information, she will likely face greater resistance. To the extent the fund manager is reluctant to sell short, some negative information might become "bottled up" within the fund, and therefore not reflected in market prices.4 This is the kind of scenario we explore.

There are some obvious reasons for institutional investors to avoid short selling. First, it is costly.5 Short sellers must determine which companies to bet against and then pay a loan fee to borrow shares to create and maintain their short positions. They must post collateral, pay ongoing margin costs, and comply with applicable regulatory requirements. Most fundamentally, to the extent the stock market overall generates positive returns, short sellers on average can expect, other things equal, to lose money.

Short selling is also risky.6 Unlike long positions, which can at most lose the amount invested in the long position if the stock drops to $0, the potential loss on a short position is infinite, growing as stock prices increase without bound. Short sellers also risk margin calls, regulatory changes, potential increases in loan fees, negative publicity, and legal actions against them when they take short positions.7 Finally, if shares are not available to borrow, a short seller might be forced to close out a position early at a loss, even if that position was part of an arbitrage strategy that ultimately would have been profitable.

In addition, short selling historically has faced a variety of cultural and regulatory obstacles, which some scholars have labeled "indirect short-sale constraints."8 To the extent these constraints apply to institutional investors, they can limit the ability of sophisticated investors to trade against the sentiment of noise traders. …

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