Veritas – Why short selling is good for your financial health

Short selling is disliked by many long-only investors, but hedge fund allocators have to thank it for industry gains so far this year, and now the Federal Reserve Bank of New York has also thrown its weight behind the contentious practice.

Research from the bank’s Current Issues in Economics and Finance newsletter revealed a number of interesting findings around the S&P 500’s fall of 6.66% on 8 August 2011.

This was the first trading day after Standard & Poor’s downgraded the US, and it produced the largest daily decline in the equity index since 2008 – so it is a useful moment to analyse what role ‘shorting’ played.

Hamid Mehran, assistance vice president in the bank’s research and statistics group, took up the challenge, with co-authors Robert Battalio and Paul Schultz (from Notre Dame’s Mendoza College of Business).

It is probably not surprising that they found shorting played only a small role in the total fall.

Many studies conclude similar things.

What makes Mehran et al’s study particularly valuable is that it calculates just how much short selling actually contributed to the 6.66% one-day slump in mid-2011. (For the full report including methodology, click here)

After studying 1843 stocks, the authors conclude: “The adjusted R-squared, a measure of the degree to which short sales can explain the drop in return – is only 0.0069. The correlation between short-selling and stock returns is low”.

The adjusted R-squared is 0.0166. “Changes in short interest, then, do not explain much of the stock price decline around the time of the bond-rating downgrade. Indeed, returns are slightly higher for stocks showing large changes in short selling – exactly the opposite of what we would expect if short selling was pushing down prices.”

The report also notes, for 1843 stocks studied, short interest in one quarter of them actually fell over the study period, “and for them short sellers were net purchasers of stock during the period”.

When reading some other reports on short selling and how it plays only a small role in markets slumping, you get the feeling the authors get close to the crux of the matter, but then they just miss it.

They say, for example, even when shorting was banned prices have kept falling, or the falls became even sharper during bans.

They give useful comments on the market conditions generally, and show elegantly that markets can fall without any help of shorting, but they do necessarily address the question ‘how much does shorting contribute to falls’.

Mehran et al’s study increases the value of the body of knowledge about shorting, not just the volume of paper spent on the matter.

Hedge fund investors are another group who should be welcoming shorting activity this year.

By Goldman Sachs’ reckoning, the 50 shorts in the S&P 500 with the highest total (USD) value of short interest outstanding made 12.4% by August. This basket excluded those stocks that were also, by the bank’s calculation, among hedge funds’ most oft-cited S&P 500 long positions.

Although the shorts basket is not the same as managers’ favourite shorts – for that you would need better position-level transparency than the industry offers – it is stocks being heavily shorted.

(The top constituents are Exxon Mobil Corp, International Bus. Machines, Chevron Corp, Walt Disney, AT&T, and Coca-Cola.)

The whole basket has done better for hedge managers than their favourite 50 long positions, which made 9%.


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