The explosive rally in GameStop, pitting retail investors against hedge funds, has renewed calls to ban short selling. But new research shows how valuable short sellers are to the efficient functioning of markets.

The importance of the role played by short sellers has received increasing academic attention in recent years. The research has demonstrated that short sellers as a group are key market intermediaries who improve the informational efficiency of prices, increase market liquidity, and in doing so, improve the efficient allocation of capital. In addition, temporary short-selling bans have been found to impede pricing efficiency. Without short sellers, equity prices can become overvalued, as only the optimists are expressing their opinions on valuations.

The research has also found that even in the presence of short sellers, anomalies (mispricings) exist, as stocks can remain overvalued. Academic research has tried to explain why the anomalies continue to persist. Among the explanations are that there are limits to arbitrage, which prevent rational investors from exploiting the anomalies. For example:

  • Many institutional investors (such as pension plans, endowments and mutual funds) are prohibited by their charters from taking short positions.
  • Investors are unwilling to accept the risks of shorting because of the potential for unlimited losses. Even traders who believe that a stock’s price is too high know they can be correct (the price may eventually fall), but they face the risk that the price will go up before it goes down. Such a price move, requiring additional capital, can force the traders to liquidate at a loss.
  • Shorting can be expensive – one has to borrow a stock to go short, and many stocks are costly to borrow because there are low supplies of available stocks from institutional investors (overvalued stocks tend to be overweighted by individual investors and underweighted by institutional investors, who are the lenders of shares). The largest anomalies tend to occur in small stocks, which are costly to trade in large quantities (both long and especially short), the volume of shares available to borrow is limited (since they tend to be owned by individual investors), and borrowing costs are often high.
  • Stocks with high short fees earn abnormally low returns even after accounting for the shorting fees earned from securities lending. In other words, short sellers leave some scraps on the table.

At the end of 2018, U.S. mutual funds had $695 billion of outstanding securities loans,

representing over 80 percent of all outstanding short interest. The funds earned more than $2 billion in lending fees during the year, with 28 percent of active funds and 61 percent of index funds lending some of their portfolio securities.