Does Perceived Information in Short Sales Cause Institutional Herding?

Abstract

The institutional herding literature demonstrates, that institutional long equity demand in period t is dependent on their long equity demand in period t-1. We, test if institutions’ long positions also rely on perceived information contained in the trades of sophisticated arbitrageurs in the form of short interest. We test two hypotheses. First, institutions perceive changes in short interest as predicting future returns. In this case subsequent institutional demand should be negatively related to changes in short interest. Second, institutions perceive short interest as correcting mispricing. In this case short-sale constrained institutions, underweight securities until short interest increases, they view prices as corrected, and subsequently purchase the security. We find that institutional demand is positively related to past changes in short interest, supporting the perceived price correction hypothesis.