Bastian von Beschwitz , Pekka Honkanen , Daniel Schmidt
Review of Finance, Volume 29, Issue 4, July 2025, Pages 1137–1188, https://doi.org/10.1093/rof/rfaf023
Over the past two decades, passive investment has transformed financial markets, with passive funds surpassing active funds in assets under management in 2019. While much research has examined the broader consequences of passive ownership—such as its effects on corporate governance, price efficiency, and investment strategies—its impact on equity lending markets remains underexplored. In this paper, we investigate how passive ownership influences securities lending and short selling, leveraging the Russell 1000/2000 index reconstitution as a natural experiment.
Short sellers rely on borrowed securities to maintain positions, making the equity lending market essential for price efficiency. Since passive funds are significant securities lenders, we hypothesize that increased passive ownership leads to greater lendable supply, facilitating short selling. While we indeed find that lendable supply grows, short selling demand increases even more, resulting in a rise in the utilization ratio. This suggests that passive ownership not only expands lending supply but also enhances its attractiveness to short sellers.
Existing work attributes this increase in short selling demand to index inclusion, governance issues, or ETF arbitrage opportunities. However, we find that these explanations do not fully account for the observed increase in short selling. Instead, we argue that passive ownership attracts informed short sellers because passive funds are stable, long-term lenders unlikely to recall loans, thereby reducing uncertainty for borrowers.
Following Appel, Gormley, and Keim (2019), we use Russell 2000 index membership as an instrumental variable to isolate the causal effect of passive ownership. We find strong evidence consistent with our hypothesis that passive owners increase both the quantity and the quality of lendable supply: in addition to increasing lendable supply and short selling, we document that passive ownership causes an increase in stock loan duration, a reduction in recalls (as proxied by fails-to-deliver), and fewer drops in lendable supply. Furthermore, we show that increased short selling by informed traders improves price efficiency, particularly around negative news events.
Our research contributes to two key areas. First, we demonstrate that passive ownership enhances short selling by not only increasing supply but also improving its stability, thereby improving market efficiency. Second, we add to the literature on equity lending by showing how ownership structure influences lending market dynamics. Our findings imply that regulatory policies affecting passive ownership should also consider their impact on securities lending and short selling.
In summary, we show that passive ownership reshapes the equity lending market by supplying high-quality loans that attract informed short sellers, ultimately improving market efficiency.