Finance & Accounting Feb 1, 2021
Rules to Limit Short-Term Trading Can Have Unintended Consequences
New research suggests that regulators should instead focus on broader investor access to information.
Short-term investors have developed a reputation as troublemakers within financial markets, at least among a certain contingent of investors and policymakers.
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This has led some prominent investors—including Berkshire Hathaway’s Warren Buffet and Jack Ehnes, CEO of the second-largest public pension fund in the U.S., CalSTRS—to sign a 2009 letter calling for an end to “value-destroying” short-termism in financial markets. The signers endorsed new tax structures that would discourage short-term trading.
The issue, they and others argue, is that short-term investors incentivize corporate leaders to focus on ratcheting up near-term profits at the expense of building long-term, sustainable financial and societal value. Some research also suggests that short-term trading increases market volatility and crashes.
Policies intended to curb short-termism include the Tobin Tax, as well as the Security and Exchange Commission’s proxy access rules, which allow long-term shareholders to nominate members of corporate boards, and a proposal to link investors’ corporate voting rights to the length of time they hold a given company’s shares. In 2019, one group went so far as to launch a Long-Term Stock Exchange.
But could these well-intentioned policies have unintended consequences—such as harming other kinds of investors as well?
Three associate professors of finance at the Kellogg School sought to determine the wider market impacts of these anti-short-termism policies—and of similar, potentially more restrictive ones that have been suggested but not yet implemented. They used a theoretical model simulating the behavior of investors operating on varying time horizons and with different levels of information about their investments.
“[Our] model is saying, look, if you don’t like the way financial markets look in the short run, the way to solve that is not by stopping people from trading with each other; it’s by trying to promote more free-flowing information so that everybody is on the same page.”
— Ian Dew-Becker
They found that some of the policies meant to discourage short-termism actually hurt both short- and long-term traders, and they propose alternatives that focus on broader access to information.
“There are times when people want to be able to trade quickly, for perfectly reasonable reasons,” says one of the authors, Ian Dew-Becker. “This model is saying, look, if you don’t like the way financial markets look in the short run, the way to solve that is not by stopping people from trading with each other; it’s by trying to promote more free-flowing information so that everybody is on the same page.”
Building a Model of Investor Interaction
The first two types—long-term and short-term investors—are the most likely to be professionals spending time digging into research on the fundamentals of their investment decisions. The third type of investors are “noise” traders, meaning those who trade their investment holdings for a reason other than an informational signal; this could be someone, for example, whose savings are tied up in stocks and who simply needs to liquidate them to buy a house.
In addition to measuring the relative profits or losses for each type of investor, the researchers also noted how policies meant to dampen short-termism affect the extent to which stock prices can be trusted to reflect the real health of companies and the economy more broadly. This is known as “price informativeness.”
The researchers’ model assumes two key features about investors: the time horizon of their investment strategies and the amount of information they acquire about the fundamentals of their investments.
“In our model, there are agents that use one particular type of strategy and stick to it; they don’t switch back and forth,” says Crouzet. “You could think of the short-term investors being, say, commodity trading companies that reorganize their portfolios several times a day. And the long-term investors could be, for example, pension funds that invest in an oil company for a very long time.”
The researchers then plugged into the model a range of restrictions simulating specific policies (both existing and proposed), including direct restrictions on investment strategies, taxes on transactions, and subsidized information acquisition so that investors at all levels have greater access to that information.
Overall, the model suggested that restrictions on trading hurt both long-term and short-term investors, while an increase in access to information about underlying investments helped prices become more informative and less volatile to speculative trading.
More specifically, moves to restrict short-term investment hurt short-run price informativeness, because they would make it harder for other investors to see and respond to negative signals about company fundamentals. Such moves also increased volatility, due to how they would interfere with all investors’ ability to cash out their investments. In terms of investor outcomes, such a move hurt the profits of short- and long-term investors, but helped noise traders.
On the other hand, subsidizing research and access to investment information hurt long-term traders because it compromised their informational advantage, but helped noise traders and short-term traders and improved price efficiency.
The researchers acknowledge that within their findings, there is a tension between efforts to help long-term investors, help noise traders, and boost price informativeness.
“No single policy helps all the groups at the same time because of a zero-sum aspect of the model,” they write in the paper, “and policies that may be attractive to certain investors can come with negative side effects for agents outside the model—for example, executives or policymakers like the Federal Open Market Committee—who might make decisions based on asset prices.”
Improving Access to Information
The finding that restricting short-term investment makes long-term investors worse off is surprising, Nathanson says.
“Even long-term investors who are trading on long-term information—like about climate change and its effect on oil prices—will actually execute some short-term trades to exploit information,” he explains. For example, a long-term investor might have made some short-term oil trades earlier this year as oil prices plummeted. “By ruling out that type of trading behavior, policymakers would actually make even long-term investors worse off.”
Dew-Becker points out that the model’s findings are bolstered by history, since policies that seek to increase disclosure have tended to stick around much longer than those that work to circumscribe trading behavior.
He explains that, in practice, subsidizing research or improved access to investment information could take various forms.
Already, corporations are required to publicly share specific information on a quarterly basis. Policies could further require government agencies to research and disseminate information about other types of economic fundamentals—for example, oil inventories or the effects of climate change on various other industries; they could also provide grants to universities to do this work.
“The paper is ultimately pushing toward this type of policy, so that nobody has some big informational advantage,” says Dew-Becker. “It’s not going to make literally everybody better off, but it’s going to make a lot of people better off, and it’s going to make prices more informative, which has some social value.”
Katie Gilbert is a freelance writer in Philadelphia.
Crouzet, Nicolas, Ian Dew-Becker, and Charles Nathanson. 2020. “On the Effects of Restricting Short-term Investment.” Review of Financial Studies. 33(1): 1-43.
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