Common Short Selling and Excess Comovement

Abstract

We show that common short sold capital can explain future four-factor excess return correlation one month ahead, controlling for many pair characteristics, including similarities in size, book-to-market, and momentum. We explore the possible explanations that could give rise to this result. Contrary to the predictions of price pressure, we find that the relationship weakens significantly with stock illiquidity. Instead, consistent with the informed trading hypothesis, the relationship is stronger when short positions originate from hedge funds, from active investors, and from short sellers with high past performance. Stocks connected by common short sellers are associated with non-transitory negative cumulative abnormal returns. Finally, we show that our results can be used to obtain diversifications benefits.