Game Over for Hard-to-Borrow Stocks?

Recent major short squeezes, such as what occurred with GameStop GME and AMC Entertainment AMC, provided remedial courses for hedge funds about the risks associated with short-selling, particularly when it involves stocks that are difficult or expensive to borrow. The increased risk has led to a decrease in shorting activity of hard-to-borrow stocks, resulting in persistent overpricing.

A large body of research has found that in both stock and bond markets, retail investors tend to be irrational, naive “noise traders” who display herdlike behavior, trading on sentiment rather than fundamentals. Further research shows that noise trading leads to mispricing (overvaluation), especially for hard-to-arbitrage stocks and during periods of high investor sentiment. Eventually, mispricings are expected to be corrected when the fundamentals are revealed, making investor sentiment a contrarian predictor of stock market returns. In addition, overpricing is more prevalent than underpricing because investors with the most optimistic views about a stock exert the greatest effect on the price; their views are not counterbalanced by the relatively less optimistic investors inclined to take no position if they view the stock as undervalued rather than a short position. Thus, when the most optimistic investors are too optimistic, overpricing results—providing opportunities for sophisticated short-sellers.

The Role of Short-Sellers

The importance of the role of short-sellers has gained increased attention from academic researchers in recent years. Short-sellers help keep market prices efficient by preventing overpricing and the formation of price bubbles in financial markets. In an efficient market, capital is allocated appropriately and economically. If short-sellers were inhibited from expressing their views on valuations, securities prices could become overvalued and excess capital would be allocated to those firms. Limits to arbitrage—such as the risks of unlimited losses when selling short, the high costs of shorting (borrowing fees can be high), and regulations that prohibit some institutions from shorting—allow anomalies to persist. The empirical research finds that market anomalies tend to derive their profitability mainly from short-selling overpriced stocks rather than buying underpriced counterparts. It’s simpler and less risky (losses are not unlimited, and there are no borrowing fees) to correct underpricing.

Research into the information contained in short-selling activity includes “The Shorting Premium and Asset Pricing Anomalies” (2014); “Smart Equity Lending, Stock Loan Fees, and Private Information” (2017); the 2020 studies “Securities Lending and Trading by Active and Passive Funds,” “The Loan Fee Anomaly: A Short Seller’s Best Ideas,” and “Pessimistic Target Prices by Short Sellers”; “Can Shorts Predict Returns? A Global Perspective” (2021); “Anomalies and Their Short-Sale Costs” (2022); and “Mining the Short Side: Institutional Investors and Stock Market Anomalies” (2023). The studies consistently found that short-sellers are informed investors who are skilled at processing information (though they tend to be too pessimistic). That is evidenced by the finding that stocks with high shorting fees earn abnormally low returns even after accounting for the shorting fees earned from securities lending. Thus, loan fees provide information in the cross-section of equity returns.

Retail investors tend to be on the other side of short-sellers. Historically, they have been exploited. However, the recent GameStop episode, in which retail investors using social media banded together with sufficient capital to engineer a short squeeze by attacking the short positions of well-capitalized hedge funds, demonstrated how risky shorting can be. In January 2021, a short squeeze resulted in a 1,500% increase in GameStop’s share price over the course of two weeks. The increase was fueled by social media users on Reddit’s WallStreetBets.

In January 2019, GameStop had an average short borrow fee of just 1%. At the time of the short squeeze, GameStop’s short borrow fee had jumped to 34%—the cost (and risk) of borrowing shares for short-selling varies significantly. Fees are influenced by the stock’s characteristics: Large, stable, and liquid stocks generally have lower borrowing costs, while smaller, volatile, and illiquid stocks can be much more expensive.

The type of shorting risk experienced in the GameStop episode was one that had never been experienced, and almost certainly was not expected—the previously highly successful hedge fund Melvin Capital lost about $7 billion betting against GME. And its short bets on some other high-flying meme stocks (shares of companies that gained viral popularity because of heightened social sentiment), such as AMC, dug it deeper in the hole, leading to the fund’s shutdown in June 2022.

Investors are able to target short-sellers because they are required to report their short positions to the Financial Industry Regulatory Authority by the 15th of each month (or the preceding business day if the 15th is not a business day). Finra compiles the short interest data and discloses it to the public eight business days later.

Game Over?

Jun Chen, Byoung-Hyoun Hwang, and Melvyn Teo, authors of the October 2023 study “Did the Game Stop for Hedge Funds?,” analyzed whether retail investors on social media platforms target hedge funds’ short positions; whether they succeed in pushing prices of stocks shorted by hedge funds; how hedge funds respond to the new threat posed by retail investors on social media platforms; and what the broader implications are for asset prices and market efficiency. They began by noting that retail investors’ share of trading volume had increased 10 percentage points, from 13% in 2011 to 23% in 2021, and that they frequently drew from social media when deciding which stocks to buy and sell. Their reliance on social media could lead to coordinated actions banding together to drive prices—it is illegal for institutional investors to engage in that behavior. The growing prevalence of retail investors and their increasingly coordinated action means that retail investors are becoming more important in setting prices, thus creating a threat to short-sellers. Among their key findings were:

• Consistent with the view that social media users react to the publication of short interest, social media activity on a stock increased following the publication date of short interest.
• Social media activity was a better harbinger of higher stock returns when hedge funds publicly disclosed put option positions on a stock or were mentioned in social media posts about that stock.
• After the first quarter of 2021, hedge funds reduced by 57% both the dollar value of and the equivalent number of shares outstanding associated with their publicly disclosed short positions on high short-interest stocks. They also sold short 67% fewer shares in high short-interest stocks. However, there was not a reduction in hedge funds’ publicly disclosed short positions on other stocks, nor a reduction in their non-publicly disclosed short positions on high short-interest stocks.
• In the process of squeezing hedge fund short positions in high short-interest stocks, social media users moved stock prices above fundamental values: Heavily shorted stocks that experienced high social media traffic and, therefore, were more likely to appreciate in price were also less likely to announce positive cash flow news.

Their findings led Chen, Hwang, and Teo to conclude, “Retail investors encourage each other on social media to pile into stocks that hedge funds currently short either for ideological reasons or in an attempt to engineer a short squeeze. The buying pressure from retail investors, perhaps exacerbated by the ensuing squeeze with hedge funds also buying to cover their short positions, cause stock prices to rise.” They added, “Our findings validate concerns raised by practitioners that it has become increasingly risky to short-sell heavily shorted stocks as social media platforms allow retail investors to mount coordinated attacks against short-sellers.”

Hard-to-Borrow Stocks

Lionel Smoler-Schatz, of the research team at Verdad, examined the relationship between high short-borrow fees and future stock returns. His focus was on “hard-to-borrow” stocks. His dataset included weekly borrow cost data from 2019 to 2023 across a broad range of equities (approximately 15,000). He hypothesized that the key predictors of whether a stock would be hard to borrow are size, trading activity, and volatility, in addition to what exchange the stock traded on. He then differentiated between hard-to-borrow stocks and what is referred to as “general collateral” stocks. Following is a summary of his key findings:

• In the US, hard-to-borrow stocks typically showed negative returns over three-, six-, and 12-month horizons, whereas general collateral stocks tended to yield positive returns over the same periods.
• High borrowing fees provided a strong signal for future returns, particularly in cases where large, previously liquid stocks became hard to borrow, often signaling impending negative returns.
• His findings led Smoler-Schatz to conclude: “We believe in most instances the most pragmatic application of hard-to-borrow data is to steer clear of taking long positions in these stocks, serving as a strategic compass in the often-tumultuous seas of market speculation.”

Investor Takeaways

A large body of evidence demonstrates that short-sellers are informed investors who play a valuable role in keeping market prices efficient—short-selling leads to faster price discovery. If retail investors were informed, their coordinated actions would lead to more market efficiency. However, since the research shows they tend to be noise traders, their increased trading can lead not only to less efficiency but even to destabilization of financial markets. They have already demonstrated that they are a threat to hedge funds that serve to keep markets efficient through their price discovery efforts and their shorting of stocks whose prices have been driven up (by sentiment-driven retail investors) to levels not supported by fundamentals.

Compounding the risks of shorting, as Xavier Gabaix and Ralph Koijen demonstrated in their 2021 study, “In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis,” that markets have become less liquid and thus more inelastic. Gabaix and Koijen estimated that today $1 in cash flow results in an increase of $5 in valuation. One explanation for the reduced liquidity is the increased market share of indexing and passive investing in general. Reduced liquidity increases risks of shorting. The result is that while the game of short-selling isn’t over for hedge funds, the threat of retail investors banding together has led to a significant decrease in their shorting activities in heavily shorted stocks. The limits to arbitrage have increased, allowing for more overpricing of “high-sentiment” (typically glamour growth) stocks, making the market less efficient.

Thus, one takeaway for advisors and investors is that we are likely to see more persistent overpricing on the wrong side of anomalies—and ultimately crashes as the fundamentals are revealed. For example, GameStop reached a high of about $120 on Jan. 21, 2021 ($483 adjusted for the 4:1 stock split on July 18, 2022). On March 18, 2024, it was trading below $15.

Another takeaway for advisors and investors is to avoid being a noise trader. Don’t get caught up in following the herd over the investment cliff. Stop paying attention to prognostications in the financial media or posts on social media. Most of all, have a well-developed, written investment plan. Develop the discipline to stick to it, rebalancing when needed, and harvesting losses as opportunities present themselves.

Finally, advisors and investors should be aware that fund families that invest systematically have found ways to incorporate the research findings on the limits to arbitrage and the evolving changes we have discussed in order to improve returns over those of a pure index-replication strategy. For example, Alpha Architect, AQR, Bridgeway, and Dimensional have long excluded from their eligible universe stocks with lottery characteristics because the historical evidence has demonstrated that limits to arbitrage allow securities with these characteristics to become overvalued. It seems likely that the ability to incorporate such strategies will become increasingly important, as the markets have become less liquid, increasing the limits to arbitrage and allowing for more overpricing. The evidence demonstrates that you should not own stocks with high borrowing fees. Forewarned is forearmed.

Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners, collectively Buckingham Strategic Wealth, LLC and Buckingham Strategic Partners, LLC. For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based on third party data and may become outdated or otherwise superseded without notice. Third-party information is deemed reliable, but its accuracy and completeness cannot be guaranteed. The securities mentioned are for educational purposes only and should not be construed as a recommendation. Past performance is not indicative of future results. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this article. LSR-23-618