Active investment management is a difficult game. Research continually shows that the majority of active fund managers fail to beat the market consistently. Just look at the latest S&P Indices Versus Active scorecard. For the 10-year period to 30 June 2020, 82% of large-cap US funds underperformed the S&P 500.
There are ways for long-only active portfolio managers to gain an edge, however. Focusing on the short side of the market is one strategy that can potentially enhance performance. Short selling data is rich with institutional sentiment information meaning that it can provide active managers with valuable insights. Here’s a look at how short selling data can add value for active investment managers.
Short selling data: valuable insights for active managers
The biggest advantage that active investment managers have over passive managers is flexibility. Not only can active portfolio managers increase their exposure to businesses that have attractive fundamentals in an effort to beat the market, but they can also decrease their exposure to businesses that are facing challenges or are overvalued.
It’s the latter strategy – avoiding potential losers – where short-selling data can provide a powerful edge. Armed with information on stocks that are being heavily shorted, or seeing a significant increase in short interest, active fund managers can reallocate their portfolios away from these stocks and avoid substantial capital losses.
Avoiding losers can make a significant difference to overall performance. Indeed, a recent paper on short selling entitled ‘Securities Lending and Trading by Active and Passive Funds’ by Pekka Honkanen of HEC Paris Business School found that active US mutual funds that loaned stock out to short sellers avoided losses of about 18% of the value of a position on average by rebalancing their portfolios away from equities that were borrowed from them.
Honkanen, who studied US stock and fund data over 16 years through 2017, found that stock loans predicted negative future returns that did not revert even 12 calendar quarters after the loan. Honkanen concluded that having access to real-time information about short selling is extremely valuable for long-only active managers.
Short-selling data predicts negative returns
Honkanen is not the only researcher to conclude that short-selling data can provide valuable insights in relation to future stock performance. A number of other academic studies have shown that short interest is inversely related to future stock performance and can be used to predict stock price declines.
For example, a 2008 study entitled ‘Which Shorts are Informed?’ by Boehmer, Jones, and Zhang showed that heavily-shorted stocks underperformed lightly-shorted stocks by a risk‐adjusted average of 1.16% over the following 20 trading days (15.6% annualized). Boehmer, Jones, and Zhang found that institutional non-program short sales were the most informative trades in terms of future downside risk – stocks heavily shorted by institutions underperformed by 1.43% over the next month (19.6% annualized).
Other studies have shown that sharp spikes in short interest can also be a bearish signal. For example, a 2011 paper entitled ‘Short Selling and Stock Returns: Evidence from the UK' by Mohamad, Jaafar, and Hodgkinson, which examined UK data between 2003 and 2010 found that unusually large increases in short interest are followed by a period of negative abnormal returns. Mohamad, Jaafar, and Hodgkinson concluded that informational content is associated with large spikes in short interest.
The takeaway from these studies is quite clear – heavily-shorted securities tend to underperform securities that are less shorted. So, the ability to rebalance portfolios away from heavily-shorted stocks is a clear advantage for long-only active managers. By shifting capital away from stock with high or increasing levels of short interest, active managers can potentially reduce downside risk substantially.
“When active funds see high demand from short sellers, they can unload the stock” – Pekka Honkanen
It's worth pointing out that short selling data is not only useful in protecting against downside risk. It can also be used to identify stocks that have the potential to outperform. Research shows that while heavily-shorted stocks often underperform, lightly-shorted stocks often outperform.
For example, a 2010 study by Boehmer, Huszar, and Jordan entitled ‘The Good News in Short Interest’ found that relatively heavily-traded stocks with low short interest experienced both statistically and economically significant positive abnormal returns. These positive returns were often larger (in absolute value) than the negative returns observed for heavily-shorted stocks.
Short sellers are well-informed traders
Why is short-selling data so powerful? Well, one reason is that short sellers tend to be well-informed, high-conviction traders.
Short sellers face a number of unique risks when they short a stock. One is that they potentially face infinite losses. While a share price can only fall to zero, there is no theoretical limit to how high a share price can rise.
Short squeezes are another key risk for shorters. A change in sentiment can lead to a high level of short-covering, with the short-sellers rushing to buy the stock. This can push the stock’s price up dramatically, resulting in large losses.
Short sellers can also face high costs to place trades. To go short, sellers first have to locate stocks they want to short. Then, they have to pay borrowing costs.
Given these risks, only investors who have strong expectations of a considerable price decline – often based on superior information – choose to short. Whereas the market is full of ‘weak’ longs – investors who hold stock because it’s part of the index or because everyone else owns it – you rarely see a weak short.
Ultimately, when you track short-selling data, you’re following those who are extremely confident in their investment theses.
Short interest data: a powerful tool for long-only investors
In summary, short-selling data has the potential to be a very powerful tool for active investment managers. Short data provides invaluable market intelligence and can help long-only active investors better manage portfolio risks.
Research shows that if a stock is heavily shorted, or has seen a large increase in short interest, there’s a high probability it will underperform. Active investors, therefore, can use short-selling data to their advantage. If investors see high demand from short sellers for a particular stock, they can reduce their positions in that stock to protect their performance.
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