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Mutual Funds Lose to Short Sellers

A new study finds that “a significant element in the profitability of [short selling] is derived from predictability in [mutual fund] trading patterns.” The researchers used daily trading data and found that the effect was more pronounced in less liquid stocks with high levels of institutional ownership. The authors also noted that trading directionally against mutual funds increased short seller returns by a factor of three when compared to trading in the same direction. When retail sentiment (as measured by flows from bond mutual funds to equity mutual funds) ranked in the top third versus the bottom third, mutual fund trading volume increased 16% and short selling profits were at their highest. The authors noted that this “wealth transfer” between mutual funds and short sellers may at least partially be responsible for mutual funds underperforming passive benchmarks. In sum, mutual funds “seem to consistently lose to [short sellers], in part because of a herding phenomenon in their trading, and in part because of longer-term predictability in relation to retail flows.”

The paper can be accessed here