Controversial “short selling” provides important benefit to market

Short sellers—investors who profit when share prices fall—are considered, by many, to be pariahs of the stock market.

But new research led by Jonathan Karpoff, the Norman J. Metcalfe Endowed Professor in Finance at the University of Washington Foster School of Business, finds that these negative investors serve a positive purpose in at least one important circumstance—when dealing in companies that cook the books.

Controversial investment strategy
Short sellers borrow shares in companies whose market value, they believe, is likely to decline. They make money by selling high and buying back low, before returning the shares according to the terms of their contract. This unorthodox profit motive pushes short sellers to doggedly seek and publicize any negative information they can find in an effort to force down the share price of the companies in which they are trading.

But does short selling create a negative or positive effect on the market? “It’s a policy concern for the Securities and Exchange Commission and others that short sellers have a deleterious effect, undermining investors’ confidence in financial markets,” Karpoff says. “But a counter argument has long been that short sellers facilitate market efficiency by getting the full picture about a company revealed in its stock price. So the question is: are short-sellers good guys or bad guys? Do they bring to light information that keeps markets honest? Or do they drive prices below their fair value, creating cascades of panic selling?”

Economic vigilante justice
With co-author Xiaoxia Lou at the University of Delaware, Karpoff investigated the volume of short selling leading up to more than 600 cases of corporate fraud and found that short sellers:

1. accelerate the average time to discovery of corporate misconduct (from 26 to 18 months).
2. dampen the inflation of a company’s share prices during the period of financial fraud.
3. do not exacerbate the inevitable share price drops when a firm’s fraud is revealed publicly.
4. predict which firms will be caught misrepresenting their finances.

The study suggests that short selling does play a beneficial role in policing corporate fraud and moderating market swoons. Its effect on the wider market? “Our study doesn’t address that big picture in a conclusive way,” Karpoff says. “But we do find that short selling activity is concentrated on—and helps expose—financial misconduct.”

The good guy/bad guy debate will likely rage on from CNBC to Comedy Central. “But for a naïve investor who’s buying shares of a company that’s cheating,” adds Karpoff, “the effect of the short seller is beneficial.”

Karpoff’s study, “Short Sellers and Financial Misconduct,” won the best paper award at the 2008 University of Chicago Center for Research in Security Prices (CRSP) Forum, and earned him and Lou a Q-Group grant to fund further study. The paper is forthcoming in the Journal of Finance.