Institutional Investors as Short Sellers?

Peter Molk is associate professor of law at University of Florida Levin College of Law; and Frank Partnoy is the Adrian A. Kragen Professor of law at University of California Berkeley School of Law. This post is based on their recent article, forthcoming in the Boston University Law Review.

Institutional investors rarely sell short. In Institutional Investors as Short Sellers?, we explore why. We examine how social welfare might be improved if institutions sold short more.

Our core argument is simple: institutional investors obtain negative information about companies, but because they rarely sell short this information is not fully reflected in prices. As an illustrative example, consider three strategies available to a mutual fund manager who regularly obtains a range of information about different companies. It is straightforward for the manager to buy a new position when she receives positive information. 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 likely will face greater resistance. To the extent the fund manager is reluctant to sell short, some negative information becomes “bottled up” within the fund.

Of course, there are some good reasons for institutional investors to avoid short selling. It is costly, risky, and has faced a variety of cultural and regulatory obstacles. These costs and risks of short selling reduce market efficiency. They impose limits to arbitrage that reduce liquidity, increase volatility, and skew the available information about individual companies, thereby leading to less accurate stock prices. When a portion of the distribution of information about a company is limited, because of the various constraints on short selling, stock prices are less likely to reflect the full array of information.

To be sure, not all institutional investors refrain from shorting. Many hedge funds sell short. And not all institutional investors should embrace shorting, given its costs and risks. Nevertheless, we argue that significant social and private welfare gains could result if more institutional investors embraced shorting, both directly, through long/short strategies, and indirectly, by tolerating and encouraging more short selling by asset managers.

In advocating that institutional investors embrace short selling, we suggest that short selling might be viewed in the same way public law scholars view some free speech actors: outlier participants in society who do not represent the views of the majority and who seek changes that would harm certain powerful institutions and individuals, but whose efforts and positions nevertheless can significantly benefit society overall.

The complete paper is available for download here.

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