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 of experiencing negative abnormal returns subsequently. Therefore, the common sense implies that it should be possible to gain an advantage of the stocks mentioned above. 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 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. Still, there is a large number of other possibilities than just accruals.

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Markets Traded
equities

Backtest period from source paper
1988-2005

Confidence in anomaly's validity
Strong

Indicative Performance
26.8%

Notes to Confidence in Anomaly's Validity

Notes to Indicative Performance

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


Period of Rebalancing
Monthly

Estimated Volatility

Notes to Period of Rebalancing

Notes to Estimated Volatility

not stated


Number of Traded Instruments
230

Maximum Drawdown

Notes to Number of Traded Instruments

depends on size of investment universe


Notes to Maximum drawdown

not stated


Complexity Evaluation
Complex strategy

Sharpe Ratio

Notes to Complexity Evaluation

Region
United States

Financial instruments
stocks

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.

Hedge for stocks during bear markets

No - The selected strategy is designed as a long-only; therefore, it can’t be used as a hedge against market drops as a lot of strategy’s performance comes from equity market premium (as the investor holds equities, therefore, his correlation to the broad equity market is very very high).

Source paper
Out-of-sample strategy's implementation/validation in QuantConnect's framework (chart+statistics+code)
Other papers

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