Does Passive Investing Help Relax Short-Sale Constraints?

Abstract

How does a shift to passive investing affect securities prices? We propose and analyze a security lending channel in which passive funds serve as significant providers of lendable shares to short sellers. Using a comprehensive sample of U.S. stocks over 2007-2017, we show that stocks with high level of passive fund ownership exhibit larger short positions, lower lending fees and longer durations of security loans. The effect of passive investors on security lending outcomes is significantly larger than the effect of actively managed funds and other institutional asset managers. Consistent with the literature on short-sale constraints, we further find that constrained stocks with more passive fund ownership exhibit lower cross-autocorrelations with negative market returns, less skewness in stock returns, and a smaller value premium. To mitigate identification concerns, we confirm our main findings using two different Russell index reconstitution methodologies that generate quasi-random variation in passive fund ownership. Our study suggests that passive investors contribute to stock price efficiency by relaxing short-sale constraints.

Keywords: Security Lending, Short-Sales Constraints, Passive Asset Management, Market Efficiency

JEL Classification: G12, G14, G23