Expected Returns and the Predictability of Equity Lending Fees

Using a novel equity lending dataset, this paper is the first to show that expected returns strongly and negatively predict future equity lending fees. In comparing two expected return measures, I find that a rational expected return has stronger predictive power of future short selling activity and loan fees than an extrapolative expected return, suggesting that short sellers are rational, forward-looking agents. In light of the importance of equity lending fees to short seller profitability, a loan fee forecasting exercise demonstrates that a) loan fees are highly predictable out-of-sample, and b) expected returns can improve the out-of-sample predictability of loan fees for stocks expected to perform poorly. Loan fee predictability has implications for future loan demand, suggesting that short sellers are drawn to short stocks with historically predictable loan fees in order to mitigate the risk of unexpected loan fee increases. I present evidence that loan demand is the primary channel through which expected returns improve fee predictability