Mutual Funds and Short-Sellers: Why does short-sale volume predict stock returns?

Daily directional trading by mutual funds (MFs) is highly-persistent and price-destabilizing, leading to return reversals lasting months.  This effect is distinct from the “flow-induced trading” phenomenon in prior studies.  At the same time, short-sale volume (SSV) reacts strongly in the opposite direction – when MFs buy (sell), SSV increases (decreases).   Daily SSV is responsive to both the expected component of MF trades (based on prior-days’ trading), and the unexpected component (based on same-day trading).  We conclude some short-sellers provide liquidity strategically in response to price-destabilizing MF trades, and this activity largely accounts for SSV’s ability to predict long-horizon returns.