When R2 meets the short-sales constraints

•We find that R2 increases after the lift of the short-sales constraints.•We document that the change of R2 is from the decrease in idiosyncratic volatility.•The result contradicts the mainstream view that high R2 means low price efficiency.•The result supports the behavioral view that more noise trading will decrease R2.

We examine the short-selling in the Hong Kong stock market and find that, after the lift of short-sales constraint, the R2 increases, contradicting the traditional wisdom that R2 is a proxy of price inefficiency. Moreover, the change of R2 is from the decrease in idiosyncratic volatility.