Manager Writes: The Art of Shorting

Eoin Murray from OMAM reviews current thinking on shorts

Eoin Murray

Along with leverage and participation, the art of shorting is often cited as one of the main differentiators of hedge fund management from traditional investing. The majority of investors operate under the restriction that they are not allowed (or find it difficult) to short stocks (an impediment that is commonly referred to as the 'long-only constraint'). Much has been written in practitioner journals about this effect, arguably most succinctly by Waring & Seigel.

To a large extent, we are dealing with a portfolio construction issue, where the weight of a stock in the benchmark index determines the extent to which it can be underweighted. For example, a fund manager might have an equally negative opinion about two stocks, one that has, say, an 8% weight in the benchmark index and the other that has a 0.5% weight. The extent of the fund manager's dislike for these stocks might loosely equate to a bearish -5% ideal relative position, which in absolute terms is implemented by holding the larger firm at a 3% weight in the portfolio and not holding the smaller company at all. Converting this into relative terms, there is an inefficiency in the inequality of the relative positions (-5% and -0.5%) that were motivated by an equivalent view.

The investment management industry is slowly responding to this artificial friction imposed in mandate guidelines that inhibits the ability of fund managers to fully express their views. We have witnessed the birth of a new type of mandate, the 'short-extension portfolio', the 'light hedge fund strategy', the '13030 strategy' or the '12020' mandate. Regardless of its name, the popularity of adding a small shorting capability to a long-only portfolio is growing. It is not certain that these strategies will enjoy universal appeal for the majority of institutional investors or mutual funds, but it seems likely that certain sophisticated investors who are already comfortable utilising alternative investing techniques may well adopt them.

Looking beyond the long-only constraint as a portfolio implementation issue, shorting could be a source, not just a means, of alpha. The traditional view, with its origins in technical analysis, was that shorting a particular stock represented a bullish signal. The idea was that the short position would eventually have to be covered and in the near term would simply give rise to latent demand for that stock, whose price would ultimately rise.

In effect the market acts as a clearing mechanism in which the price of a stock represents an equilibrium point for differing views. Investors engage in research on a company and that leads them to hold different opinions about its future performance (split between optimistic and pessimistic views). Those investors with bullish opinions will hold long positions in the stock; while bearish investors may want to short it, but are constrained from doing so and can only sit out of the market in that stock (i.e. have no holding, as in our simple example above). Stock prices therefore, at least partially, are biased towards the opinions of optimistic investors. Based on this hypothesis, we should reasonably expect that the prices of some stock prices are too high and that this will lead to lower subsequent returns. Furthermore, it seems likely that this particular market dynamic could not be entirely arbitraged away unless the long-only impediment is completely removed.

In economic terms, the downward-sloping demand curve DD represents the aggregate market view. However, we can see that it is effectively comprised of two separate demand curves, that of the pessimists (SS) and that of the optimists (LL). Without a long-only constraint, the market clears at price, Pn, where demand is fully satisfied. But consider now the impact of the long-only constraint, which removes at least some of the short appetite, then the clearing price must lie somewhere between Pn and Ps. Over time the price ought to revert towards its true value (Pn), representing an an alpha opportunity.

Only in 1977 did Miller convincingly document the relationship between short constraints and negative abnormal returns. A recent empirical study found an average outperformance of around 400bp per annum representing the differential quintile returns of spread portfolios for the period December 1978 to September 2003 for 1,500 US stocks. The returns were remarkably consistent through time, with the strategy having greatest efficacy for small- and mid-cap stocks, as well as the growth universe. Additionally, there is global evidence linking short selling permissiveness (feasibility and extent practiced) to efficient price discovery around the world.

Only in 1977 did Miller convincingly document the relationship between short constraints and negative abnormal returns. A recent empirical study found an average outperformance of around 400bp per annum representing the differential quintile returns of spread portfolios for the period December 1978 to September 2003 for 1,500 US stocks. The returns were remarkably consistent through time, with the strategy having greatest efficacy for small- and mid-cap stocks, as well as the growth universe. Additionally, there is global evidence linking short selling permissiveness (feasibility and extent practiced) to efficient price discovery around the world.

The task then becomes one of identifying those stocks where the long-only constraint bites hardest. A number of academic studies have been conducted in this area. The key to unlocking the power of this anomaly would appear to rest with being able to quantify the difference in opinion among investors.

Different proxies have been considered as being indicative of this anomaly:

1. Short interest level or ratio
(Figlewski, Asquith et al, etc.)

Typically expressed as the number of shares sold short divided by the number of shares outstanding, or the number of sharessold short divided by the ADV, the short interest level or ratio is seen as a proxy for the range of differing views in the market. Although there may be problems with the timeliness of data and with data availability, there does appear to be a modest relationship with future stock returns. The empirical evidence broadly supports the notion that the price of stocks with relatively more unfavourable information is too high, even in the presence of the options market, as an alternative means of implementing short positions.

2. Rebate rate for stock loans
(Jones & Lamont, etc.)

Examining older (1926-33) data direct from the stock borrowing market, one can observe that stocks can be overpriced in the presence of short sale constraints. Jones and Lamont find that those stocks that are most expensive to borrow exhibit low subsequent returns, consistent with the overpricing hypothesis.

3. Differences in analyst opinions
(Diether, Malloy & Scherbina, etc.)

Diether et al explore the notion that stocks where analysts' earnings estimate divergence is largest, are most likely to be companies where there is considerable disagreement over their prospects. The authors find the effect greatest amongst small stocks and conclude that dispersion is not a proxy for risk.

4. Divergent expectations
(Lee & Swaminathan, etc.)

The authors document a relationship between recent trading volume and the degree of broad market interest in a stock. Extending this to focus further on stocks that have been relatively more volatile in the recent past, one can build a model of divergent expectations in the market and track the relationship with subsequent stock returns.

5. Breadth of ownership
(Chen et al, etc.)

Breadth of ownership is typically measured as the change in the proportion of institutional investor ownership for any given stock. Changes in breadth are documented as an indicator of the degree to which the short-sale constraint can be expected to affect stock prices. For stocks where it binds most tightly, prices are shown to be high relative to fundamental values and their expected returns are low.

It seems likely that, at least until 'short-extension portfolios' or '13030 mandates' become more mainstream, the long-only constraint will remain a market anomaly, providing a potential source of alpha for astute fund managers.

Bibliography

Asquith, Paul, P.A. Pathak, & J. R Ritter, "Short Interest, Institutional Ownership and Stock Returns", Journal of Financial Economics, November 2005
Chen, Joseph, H. Hong & J.C. Stein, "Breadth of Ownership and Stock Returns", Journal of Financial Economics, November 2002 Diether, Karl B, C.J. Malloy & A. Scherbina "Differences of Opinion and the Cross-section of Stock Returns", Journal of Finance, October 2002
Figlewski, Stephen, "The Informational Effects of Restrictions on Short Sales: Some Empirical Evidence", Journal of Financial and Quantitative Analysis, November 1981
Jones, Charles M. and O.A. Lamont, "Short Sale Constraints and Stock Returns", Journal of Financial Economics, November 2002 Lee, Charles M.C. and B. Swaminathan, "Price Momentum and Trading Volume", Journal of Finance, October 2000
Miller, Edward M., "Risk, Uncertainty and Divergence of Opinion", Journal of Finance, September 1977