Short Interest Effect - Long-Short Version

In the past, academic research has showed that stocks with the high levels of short interest are connected with a high probability to subsequently experience negative abnormal returns. Therefore, the common sense implies that it should be possible to gain an advantage of the aforementioned stocks. The theory says that shorting stocks with all the constrains (connected with the shorting) is most often made by the informed investors whose activity ultimately helps prices incorporate more information. Moreover, the level of their holdings has predictive power about returns and fundamentals of the stocks. Knowing the short-interest can lead to a strategy that consists of simply joining informed short-sellers. The long-short variation (our screener includes also the long only variant) of this strategy would be simply performed by the shorting stocks with a high short interest and going long stocks with a low short interest.

Overally, the academic world support this anomaly, for example Asquith, Pathak and Ritter in their work "Short Interest, Institutional Ownership, and Stock Returns", say that "Stocks are short sale constrained when there is a strong demand to sell short and a limited supply of shares to borrow. Using data on both short interest, a proxy for demand, and institutional ownership, a proxy for supply, we find that constrained stocks underperform during 1988-2002 by a significant 215 basis points per month on an EW basis, although by only an insignificant 39 basis points per month on a VW basis. For the overwhelming majority of stocks, short interest and institutional ownership levels make short selling constraints unlikely." Additionaly, the authors of this paper state that: "The cross-sectional relation between short interest and future stock returns vanishes when controlling for short sellers’ information about future fundamental news. Thus, short sellers contribute, in a significant manner, to price discovery about firm fundamentals." Last but not least, this long-short strategy has a low correlation to the overall market and therefore the strategy could have a usage as a portfolio diversifier.

Fundamental reason

The literature offers two popular explanations for this predictability, namely the overvaluation hypothesis and the information hypothesis. The first possible explanation for the short interest effect - the overvaluation hypothesis stems from the work of Miller (1977). His theory says, that stocks with high levels of short interest are overvalued because pessimistic investors are unable to establish short positions, leaving only the optimists to participate in the pricing process. In this model, market forces are unable to prevent overpricing in the amount of shorting costs when these costs are high. The greater the shorting costs, the greater the possible overpricing, and therefore, the lower the subsequent stock returns.

The second and probably more valid explanation is the information hypothesis. The information hypothesis builds on a broadening base of empirical research demonstrating that short sellers are well informed traders. The aforementioned could be the reason for the functionality, because if one follows the decisions of the short-sale practitioners, whose tend to be investors with superior analytical skills (for example according to the research of Gutfleish and Atzil, 2004). The main idea is simple, the research says, that this type typically initiate short positions only if they can infer low fundamental valuation from public sources. For example, short sellers may engage in forensic accounting, looking for high levels of accrual as evidence of hidden bad news, but there is a large ammount of possibilities than just accruals.

Markets traded
equities
Confidence in anomaly's validity
Moderately strong
Notes to Confidence in anomaly's validity
Period of rebalancing
Monthly
Notes to Period of rebalancing
Number of traded instruments
1000
Notes to Number of traded instruments
it depends on investor's need for diversification (usually 100-1000)
Complexity evaluation
Complex strategy
Notes to Complexity evaluation
Strategy complexity depends on number of stocks investor wishes to include into his/her portfolio, as strategy could be much simpler for execution if investor picks less stocks.
Financial instruments
stocks
Backtest period from source paper
1988-2005
Indicative performance
19.70%
Notes to Indicative performance
per annum, annualized monthly return 1,51% (geometrically), data from table 3, around 22.70% pure alpha based on four factor model (market, size, book, momentum)
Estimated volatility
17.14%
Notes to Estimated volatility
estimated from t-statistics, data from table 3
Maximum drawdown
not stated
Notes to Maximum drawdown
Sharpe Ratio
0.92

Keywords:

stock picking, equity long short

Simple trading strategy

All stocks from NYSE, AMEX and NASDAQ are part of the investment universe. Stocks are then sorted each month into short-interest deciles based on the ratio of short interest to shares outstanding. The investor then goes long on the decile with the lowest short ratio and short on the decile with the highest short ratio. The portfolio is rebalanced monthly and stocks in the portfolio are weighted equally.

Hedge for stocks during bear markets

Not known - Source and related research papers don't offer insight into correlation structure of proposed trading strategy to equity market risk, therefore we do not know if this strategy can be used as a hedge/diversification during time of market crisis. Strategy is built as a long-short, but it can be split into 2 parts. Long leg of strategy is surely strongly correlated to equity market however short-only leg can be maybe used as a hedge during bad times. Rigorous backtest is however needed to determine return/risk characteristics and correlation.

Source Paper

Akbas, Boehmer, Erturk, Sorescu: Why Do Short Interest Levels Predict Stock Returns?
https://pdfs.semanticscholar.org/0641/8ef437dc7156229532a97d0f8392373eb297.pdf
http://comp.uark.edu/~tjandik/seminar/ShortSales_JAN_31_2008_TFF.pdf
Abstract:
High levels of short interest predict negative abnormal returns, but the reasons for this predictability are not well understood. Two popular explanations suggest very different interpretations. According to Miller (1977), stocks are overvalued in the presence of short-sale constraints, and the subsequent negative abnormal returns represent a correction of this overvaluation. Based on recent evidence in the accounting and microstructure literature, an alternative explanation is that short sellers are highly informed traders and short interest, therefore, predicts future returns due to its information content. We discriminate between the overvaluation and the information hypotheses and find support for the latter. Therefore, our evidence suggests that short sellers act as specialized monitors who generate value-relevant information in the stock market.

Hypothetical future performance

Other Papers

Asquith, Pathak, Ritter: Short Interest, Institutional Ownership, and Stock Returns
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=525623
Abstract:
Stocks are short sale constrained when there is a strong demand to sell short and a limited supply of shares to borrow. Using data on both short interest, a proxy for demand, and institutional ownership, a proxy for supply, we find that constrained stocks underperform during 1988-2002 by a significant 215 basis points per month on an EW basis, although by only an insignificant 39 basis points per month on a VW basis. For the overwhelming majority of stocks, short interest and institutional ownership levels make short selling constraints unlikely.

Boehmer, Huszar, Jordan: The Good News in Short Interest
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1405511
Abstract:
We study the information content in monthly short interest using NYSE-, AMEX-, and NASDAQ-listed stocks from 1988 to 2005. We show that stocks with relatively high short interest subsequently experience negative abnormal returns, but the effect can be transient and of debatable economic significance. In contrast, we find that relatively heavily traded stocks with low short interest experience both statistically and economically significant positive abnormal returns. These positive returns are often larger (in absolute value) than the negative returns observed for heavily shorted stocks. Because stocks with greater short interest are priced more accurately, our results suggest that short selling promotes market efficiency. However, we show that positive information associated with low short interest, which is publicly available, is only slowly incorporated into prices, which raises a broader market efficiency issue. Our results also cast doubt on existing theories of the impact of short sale constraints.

Akbas, Boehmer, Erturk, Sorescu: Short Interest, Returns, and Fundamentals
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2216919
Abstract:
We show that short interest predicts stock returns because short sellers are able to anticipate bad news, negative earnings surprises, and downward revisions in analyst earnings forecasts. They appear to have information about these events several months before they become public. Most importantly, the cross-sectional relation between short interest and future stock returns vanishes when controlling for short sellers’ information about future fundamental news. Thus, short sellers contribute, in a significant manner, to price discovery about firm fundamentals, but the source of their information remains an open question.

Beneish, Lee, Nichols: In Short Supply: Equity Overvaluation and Short Selling
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2362971
Abstract:
We use detailed security lending data to examine the relation between short sale constraints and equity overvaluation. We find that stocks’ “special” status exhibits a non‐linear (U‐shaped) relation with their short interest ratio (SIR), and that a stock’s special status, rather than its SIR, predicts negative returns. We show that short‐sellers trade on a variety of firm characteristics and against high sentiment. Specifically, we find: (1) the abnormal returns to the short‐side of nine market ‘anomalies’ identified in prior work are attributable to special stocks; and (2) future negative returns to special stocks are directly related to the lendable inventory in each stock rather than to its shares borrowed. Overall, our results suggest returns to the short side of documented ‘anomalies’ may not be obtainable without significant cost, and that the supply (available inventory) of lendable shares is the primary binding constraint to informational arbitrage in the case of equity overvaluation.

Callen, Fang: Short Interest and Stock Price Crash Risk
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2426490
Abstract:
Using a large sample of U.S. public firms, we find robust evidence that short interest is positively related to one-year ahead stock price crash risk. The evidence is consistent with the view that short sellers are able to ferret out bad news hoarding by managers. Additional findings show that the positive relation between short interest and future crash risk is more salient for firms with weak governance mechanisms, excessive risk-taking behavior, and high information asymmetry between managers and shareholders. Empirical support is provided showing that the relation between short interest and crash risk is driven by bad news hoarding.

Jordan, Riley: The Long and Short of the Vol Anomaly
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2442902
Abstract:
On average, stocks with high prior-period volatility underperform those with low prior-period volatility, but that comparison is misleading. As we show, high volatility is an indicator of both positive and negative future abnormal performance. Among high volatility stocks, those with low short interest actually experience extraordinary positive returns, while those with high short interest experience equally extraordinary negative returns. The fact that publicly available information on aggregate short selling can be used to predict positive and negative abnormal returns of great magnitude points to a large-scale market inefficiency. Further, based on the evidence in this study, the current “low vol” investing fad has little or no real foundation.