In Praise of Short Sellers

Short selling is perhaps the most difficult investment strategy.
 
Markets go up over time, so short sellers are starting with a negative expected return bet and have to generate massive alpha just to break even. They then must do the hard work to uncover hidden information, expose financial wrongdoing, identify mispriced risks, and warn of deteriorating market conditions. The companies they are shorting often fight back.
 
To make it even more difficult, there are structural risks. Short sellers must then borrow the shares, post collateral, and pay a loan fee. Loan recalls, changing loan fees, margin calls, and regulatory changes make their jobs even more difficult.
 
Short selling is difficult, costly, and risky. And short sellers have not had the best run of late, with the HFRI Short Bias Index down almost 11% in 2017. Institutional investors have been pulling money from short sellers, leaving allocations near all-time lows.
 
We believe short sellers are more important, and more valuable to the proper functioning of markets, than their recent performance or current assets under management might suggest. Short sellers may uncover hidden risks, and their trades might make stock markets more efficient.
 
A growing body of academic literature argues that short interest can identify stocks likely to underperform the market – and that this signal can complement better known market signals like value and momentum.  This research suggest that if there is substantial short interest in a stock, long-only investors would do well to beware.
 
A 2008 Journal of Finance article found that stocks with high short interest underperform stocks with low short interest by a risk-adjusted average of 1.07% per month (14% on an annualized basis).
 
More recently, the economists Alexander Ljungqvist and Wenlan Qian examined every report published by short-sellers over a five-year period. They found that when short sellers published a report on a company, the company's shares fell by 8.2% on average on the day the reports were issued. Three months later, the shares were down an average of 21.9%, and a year later, by 56.8%. These short-selling reports were presenting valuable information that served to correct major market mispricings. A quarter of the companies identified in these reports ended up being investigated by the US Department of Justice or the Securities and Exchange Commission.

The risk of short selling helps explain why short interest data is so predictive. Researchers have found that the predictive power of short interest is particularly strong among stocks where the risks to short-selling are the highest (as measured by high variance in loan utilization and lending fees). Short sellers are disciplined by these risks to focus on tangible, near-term catalysts.

Long-only equity investors can benefit greatly from paying attention to what the shorts are doing. By using short interest data as a negative signal or risk management tool, long-only managers can benefit from the insights of the short sellers.