Short Selling Found to Lead to Higher Returns

Three researchers found that short interest (the percentage of shares sold short) is a better indicator of future returns than than many other financial metrics.

Three researchers argue that short selling—a trade in which securities are sold first and then repurchased on a later date—leads to higher returns. Their paper finds that short interest (the percentage of shares sold short) is a better indicator of future returns than dividend yields, the dividend payout ratio, the price-earnings ratio, the price-to-book ratio and bond yield spreads, among other factors.

The authors interpret their findings as showing that short sellers “possess an information advantage…in other words, short sellers are informed traders.” They further argue that short sellers are “also skilled at processing aggregate information.” This could be the case if these traders are compensated for their skills at acquiring and analyzing data about future cash flows. The higher returns could also be reflective of the higher return premium required for accepting the risks associated with shorting.

Short sellers could also benefit from a relative lack of competition from other traders. The aggregate proportion of shares sold short peaked at 8.93% in July 2008, according to the study. Since the limits to arbitrage have remained relatively low, the returns to shorting have stayed relatively constant over the survey period of 1973 through 2014.

An interesting finding in the research was a greater variation in the level of short interest in mid-cap stocks. Even though large-cap stocks are likely less expensive to short, they show “relatively little variation in short-interest.” The researchers theorize that mid-cap stocks are more exposed to broad market and economic shocks. Another reason might be related to the flow of information, which would be comparatively less for mid-cap stocks. The study’s authors say further research would be needed to specifically identify the actual cause.

The researchers calculated an aggregate short interest as the equal-weighted mean of all asset-level short-interest data. They included stocks and real estate investment trusts (REITs) in their analysis as well as exchange-traded funds (ETFs) when they became available.

Short selling is risky with limited gains and potentially unlimited losses. To find out more about it, see “Shorting: A Strategy for Profiting from Price Declines” in the March 2016 AAII Journal.

Source: “Short Interest and Aggregate Stock Returns,” David Rapach, Matthew Ringgenberg and Guofu Zhou, Journal of Financial Economics accepted manuscript 2016.