High-profile episodes, such as that involving GameStop, have led some to advocate for banning short selling. But new research confirms that short sellers play a valuable role in keeping markets efficient and preventing prices from overshooting their intrinsic value.

To sell a stock short, betting that the price will fall and allowing the shorter to buy it back in the future at a lower price, the trader must borrow shares and pay a loan fee. The borrowing fee reflects the demand for shorting by traders (as well as the supply by lenders of stock, generally institutions). Thus, stocks with the highest loan fees represent the strongest conviction on the part of short sellers. Those shorting play a valuable role in keeping market prices efficient, allowing for the efficient allocation of capital. 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.

Research into the information contained in short-selling activity, including the 2016 study, “The Shorting Premium and Asset Pricing Anomalies,” the 2017 study, “Stock Loan Fees, Private Information, and Smart Lending” and the January 2020 study, “Securities Lending and Trading by Active and Passive Funds,” has found that short sellers are informed investors who are skilled at processing information. Those studies found 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.