Discussion of Short Sales Constraints and Momentum in Stock Returns

Abstract

Data on the cost of short selling stocks has been noticeable by its almost entire absence until recently, and the research implications of such ignorance for both developments in asset pricing theory and the empirical implementation of investment strategies is only recently coming to be better understood. Finance theory makes very strong assumptions about the ability of arbitrageurs to borrow and sell short large amounts of stock at no cost (see Fama, 1965 and 1970; and Ross, 1976). Yet while short selling is central to the theoretical foundations of the Efficient Markets Hypothesis and asset pricing theory, there has been relatively little discussion regarding the mechanics, costs, feasibility and extent of short sales, let alone its market impact. That constraints on short selling, whether formal and legalistic, or informal and cultural, can lead to overpricing of securities is the single most important theme of the literature: these securities may well have low future returns until the overpricing is fully corrected. Further, while direct trading costs such as bid-ask spreads and commission are incurred when buying or selling a position, short sale costs are a holding cost and hence related to the length of time a short position is maintained: this may well be for several months or even years for certain strategies such as momentum or value versus growth, and hence they will be greater than direct transaction costs. In this discussion we concentrate on short sales of equities, 1 we begin with a discussion of the perceived restrictions on short selling, together with the implications of these restrictions and the information content of changes in short interest. We then turn to the mechanics of short selling, the key facts that have emerged from proprietary data in recent years, and the extent of short selling restrictions in a global context. We then examine how data issues have influenced research before