Short Interest Effect – Long Only version

In the past, academic research has proved that stocks with high levels of short interest are connected with a high probability to experience negative abnormal returns subsequently. 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 constrain (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. Additionally, if we consider only the long-leg of the possible strategy, an easily shorted stock that is completely avoided by short-sellers suggests unanimity among market participants that the stock is, at a minimum, not overvalued. Academic research not only supports this theory, but it has shown that it is profitable to own stocks with very low short interest. Therefore, the trading strategy simply consists of holding stocks with low short interest.

Overall, 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.” Additionally, 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, the main advantage of the aforementioned utilization of the anomaly is that it could be easily implemented as a long-only strategy, while still having attractive parameters (e.g., a small market beta).

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 that demonstrates 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, who 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 these investors 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 number of other possibilities than just accruals.

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Markets Traded
equities

Financial instruments
stocks

Confidence in anomaly's validity
Strong

Backtest period from source paper
1988-2005

Notes to Confidence in Anomaly's Validity

Indicative Performance
26.8%

Period of Rebalancing
Monthly

Notes to Indicative Performance

per annum, annualized monthly return 2,0% (geometrically), data from table 1


Notes to Period of Rebalancing

Estimated Volatility

Number of Traded Instruments
230

Notes to Estimated Volatility

Notes to Number of Traded Instruments

depends on size of investment universe


Maximum Drawdown

Complexity Evaluation
Complex strategy

Notes to Maximum drawdown

Notes to Complexity Evaluation

Sharpe Ratio

Simple trading strategy

All stocks from NYSE, AMEX and NASDAQ are part of the investment universe. The short-interest ratio is used as the predictor variable. Stocks are sorted based on their short interest ratio and the first percentile is held. The portfolio is equally weighted and rebalanced monthly.

Source paper
Boehmer, Huszar, Jordan: The Good News in Short Interest
- 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.

Other papers
Akbas, Boehmer, Erturk, Sorescu: Why Do Short Interest Levels Predict Stock Returns?
- 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.

Asquith, Pathak, Ritter: Short Interest, Institutional Ownership, and Stock Returns
- 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.

Akbas, Boehmer, Erturk, Sorescu: Short Interest, Returns, and Fundamentals
- 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
- 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
- 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
- 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.

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