OWNERSHIP STRUCTURE, EXPECTATIONS, AND SHORT SALES ON THE NASDAQ

Journal of Economics and Finance, Spring 2007 by Graham, J Edward, Hughen, J Christopher

Abstract

We estimate expected short interest for Nasdaq stocks. Extending prior work, our research is among the first to investigate the impact of ownership structure on short-selling activity. We find that short interest is negatively related to institutional ownership and positively related to inside ownership; stocks with greater liquidity and smaller relative spreads are more heavily shorted. We also develop a measure of the unanticipated level of short selling; relative to the reported amount of short interest, this unexpected level of short selling seems at first to better represent the opinions of informed investors engaging in costly short-selling activities. However, the power of the unanticipated level of short-selling factor is displaced when we make allowances for traditional market, firm-size, and momentum variables.

(JEL G12, G14)

Introduction

Thomas (2006) affirms the struggle of financial researchers as they consider short sales. Confronting institutional and statistical issues, a new short sales literature has evolved in the past few years; we seek to temper the struggle with a set of related examinations that extend this research. First, we examine the impact of ownership structure on the level of short interest and find it significantly related to short-selling activity. second, we extend our ownership measures and discover that while short selling is negatively related to institutional ownership, it is positively related to inside ownership; this latter relationship is not an artifact of the non-monotonic relationship between ownership concentration and firm value documented by Morck et al. (1988). Third, we find that short sellers are more active in stocks with greater liquidity and smaller relative bid-ask spreads. Finally, we measure expected short interest and demonstrate that our measure of the unanticipated level of short interest seems to provide greater explanatory power for future returns than do the raw measures of short sales; however, this greater power is displaced when we adopt selected firm size and momentum variables as additional explanatory factors.

In advancing our understanding of short selling, we connect two lines of research. First, the literature provides evidence of negative long-run underperformance for stocks experiencing high short interest [see Asquith and Meulbroek (1995), DeChow et al. (2001), and Desai et al. (2002)]. These authors suggest that high short-interest levels often reflect the negative opinions of informed investors. Another group examines factors that influence the amount of short-sales activity. They reach several conclusions: the level of institutional ownership can constrain the ability to borrow shares [see D'Avolio (2002), Jones and Lamont (2002), and Geczy et al. (2002)], short sellers prefer liquid stock with high ratios of market to fundamental values [see DeChow et al. (2001)], and, finally, stocks with exchange-traded options attract greater levels of short interest [see Figlewski and Webb (1993)].

We measure expected short interest in a manner that frames the influence of ownership structure and other factors simultaneously. We incorporate new measures that are among the first to consider the effect of inside ownership on short interest. Given that many factors likely influence the level of short selling, it is difficult to interpret the signal provided by the informed investors that frequently engage in this activity. Towards examining this signal, we also measure whether the unexpected level of short interest provides greater predictive ability for subsequent stock returns than the absolute measures of short sales.

We provide several insights into the factors influencing the amount of short-selling activity. First, we document a negative relation between short interest and institutional ownership. On the surface, this finding seems to contradict recent research showing that institutional investors are the dominant participants in the market for lending shares for short selling [see D'Avolio (2002), Jones and Lamont (2002), and Geczy et al. (2002)]. However, stocks that are unavailable for borrowing tend to have small market capitalizations, and for stocks with large market values, the ability to borrow shares from institutions does not appear to be a significant constraint; this echoes recent findings by Asquith et al. (2005). Our analysis of large Nasdaq stocks is consistent with sophisticated short sellers being less active in stocks disproportionately purchased by institutional investors, shown by Wermers (2000) and Pinnuck (2003) to demonstrate superior stock-selection ability.

second, we discover a positive relation between inside ownership and short interest. By taking larger positions in firms with higher agency costs from entrenchment, short sellers may act to profit from a depreciative effect on corporate performance of excessive inside ownership. This new finding implies that short sellers may be using inside ownership data in their short-selling decisions, or that the factors upon which short sales choices are made are themselves tied into inside ownership levels. The inside ownership findings are not an artifact of the non-monotonic relationships between ownership concentration levels and firm value as portrayed by Morck et al. (1988). The average inside ownership levels of our sample imply such a relationship, but such is not the case.