From Gerd Kommer and Praval Kapoor
Some readers of this blog will still remember a strange stock market event in January 2021: the incredible price rise and subsequent collapse of the American GameStop share (WKN: A0HGDX). At the start of the GameStop price explosion on January 4, 2021, the share price of this previously inconspicuous, rather dusty secondary stock with an outdated business model was around $4.50. In the 13 years from the beginning of 2008 to the end of 2020, the price of GameStop shares fell by a cumulative 70%. At the beginning of 2021, GameStop appeared to be an obvious loser stock for this reason.
The GameStop story
GameStop sold computer games and other “consumer software” to private customers. That sounds modern at first, until you realize that GameStop was a brick-and-mortar retailer, conducted its retail business in the old-fashioned way from around 5,000 stores, mainly in the USA, Canada and Australia, and competed as a dwarf with the purely internet-based app store giants from Apple, Google and others. The majority of GameStop stores were loss-making and often locked in long-term leases.
In January 2021, that all seemed to change. Over the three weeks from January 4th, the GameStop price rose from $4.50 to a peak of $81, i.e. by a ridiculous 1,700 percent. Until June 2021 there was a sideways movement with strong swings up and down. The stock then gradually fell over two and a half years to around $15 today (beginning of December 2023).
What had happened? A significant portion of GameStop shares had been shorted by some hedge funds in early 2021 due to the company's chronic operating losses, unattractive business model, strange statements from the CEO, and an apparent lack of future strategy. By shorting, the hedge funds speculated that the share price would continue to fall.
GameStop becomes a meme stock
But for reasons that are still unclear, the ugly duckling GameStop suddenly became one Meme stock, a stock whose price has been made the subject of collective anti-establishment buying speculation by young, mostly inexperienced retail investors on social media - from the perspective of these retail investors, an epic David versus Goliath battle. David was a swarm of small investors, Goliath was the Wall Street establishment in the form of several hedge funds. As we all know, hedge funds have an unsympathetic image of greed, gigantomania and wealth in the general public, although at least size and wealth are not the case for the vast majority of the approximately 15,000 hedge funds worldwide. Over 90% of them are likely to be very small and not very profitable for their operators and the investors in the funds. [1]
During this “short squeeze” (literally “squeezing out short sellers”), the many thousands of small investors coordinated, among other things, via Twitter and TikTok. They managed to push GameStop's price to dizzying heights in January and February 2021. The extreme price increase caused losses in the billions for the hedge funds in question, which had speculated on a falling GameStop price.
This strange capital market episode has now even been processed by Hollywood.
The film with the title Dumb money was released in German cinemas a few weeks ago and tells the story of this David versus Goliath battle from the perspective of some small investors.
Can one conclude from the GameStop event that short sellers - the majority of whom are hedge funds, as with GameStop, mostly lose money? No, you can't.
The facts about the success of short sellers
The opposite is true. Institutional short sellers are statistically correct in their bets on falling prices in more than half of all cases. [2] GameStop was an exception to the rule (Chen/Liang/Sun 2023, Aharon et al. 2023).
In fact, stocks that are heavily shorted relative to other stocks during a given period will, as a group, produce below-market returns during that period. Reason: Short sellers tend to be very well-informed traders, in scientific jargon “short sellers are informed traders.” These are to be distinguished from the majority Noise Trader, speculatively oriented private investors who buy and sell based on a hodgepodge of signals, i.e. useless “noise”. In the long term, these noise traders perform worse in terms of cost and risk than a simple broadly diversified buy-and-hold strategy (Chague 2023). The empirical evidence for this is overwhelming. At the end of this blog post we provide a selection of scientific articles that prove this.
Stocks in which a particularly high proportion of the total holdings are the subject of short selling at a given time are stocks with high “short interest” or high “short ratio”. [3] “High short interest” in a stock is a relatively reliable statistical signal that it is better not to buy these stocks as long as the high short interest exists or, if you already own them, perhaps to sell them. An academic paper says “short interest is a strong bearish indicator” (Gorbenko 2023).
The scientific evidence for high short interest as a sell signal appears clear and unambiguous - clearer than for many other scientific findings on the basis of which professional investors or experienced private investors make investment decisions.
For US stocks, for example, For example, for the five-year period from 2015 to 2019, it was shown that the (very small) group of stocks with the highest short interest (i.e. the most intensively shorted stocks) underperformed the general market by more than six percentage points p.a. (Gargano 2021). For the eight years from 2011 to 2018, U.S. stocks that were subject to securities lending (and were therefore most likely short-sold stocks) had worse returns than stocks that were not (Crabb/Hendrix 2020) by more than four percentage points per year.
In general, research shows unequivocally that, despite their bad reputation among the public, among CEOs of affected companies and in politics, short sellers play a positive role in the functioning of the stock market. They help ensure that share prices are as close as possible to their intrinsic, i.e. technically fair, share value at all times and thus protect private investors in particular from being ripped off too often by institutional investors (Swedroe 2023). It also applies to ecologically oriented investing that short selling promotes the idea of sustainability (Managed Funds Association 2022).
Implementation in practice
How can you take advantage of this insight – “Stay away from stocks that are currently being shorted particularly frequently” – as a private investor?
This might be difficult for do-it-yourself investors. Although there are free US financial portals (e.g. Yahoo Finance) that provide short interest for most US stocks, this free data is typically not up to date and therefore useless for active trading purposes. If anything, the problem is even greater when it comes to non-U.S. stocks because adequately up-to-date short interest information is even more difficult for retail investors to find.
What about financial products that have built the exploitation of this robust statistical pattern into their investment strategy? For example, active investment funds, passive ETFs, certificates or other financial products available to private investors in German-speaking countries. With one exception, we are not aware of any such products.
This one exception – beware of advertising – is this L&G Gerd Kommer Multifactor UCITS ETF – WKN: WELT0A (accumulating) or WKN: WELT0B (distributing). Although the high-short interest stocks exclusion is not the most important individual feature of our “World AG ETF”, it is one that can contribute to a more attractive return-risk combination in the long term.
Further information about the GK ETF is available here.
Endnotes
[1] In previous blog posts we have taken a closer look at the unimpressive performance of the world's largest hedge funds and the disastrous performance of the global hedge fund sector over the last 15 to 20 years, e.g. b. here and here.
[2] Being correct in the negative price opinion does not necessarily mean that the hedge fund in question is making money. If the fund uses too much leverage and the timing of its short bet is too imprecise, it could still lose money.
[3] The Nasdaq stock exchange definition of short interest: “Short interest represents the total number of a company’s shares sold short that have not yet been covered and is commonly expressed as a percentage of shares outstanding.” A short interest rate of 1% is considered normal (i.e. low), a rate of around 10% is considered high.
literature
Aharon, David et al. (2023): "Did David win a battle or the war against Goliath? Dynamic return and volatility connectivity between the GameStop stock and the high short interest indices"; In: Research in International Business and Finance; Vol. 64, Jan. 2023
Boehmer, Ekkehart/Charles Jones/Xiaoyan Zhang (2008): “Which shorts are informed?” In: Journal of Finance; 63; Issue 2; April 2008
Boehmer, Ekkehart/Charles Jones/Juan Wu/Xiaoyan Zhang (2020): “What do short sellers know?” In: Review of Finance; 24; Issue 6; Nov 2020
Boehmer, Ekkehart/Zsuzsa Huszár/Yanchu Wang/Xiaoyan Zhang/Xinran Zhang: (2020): "Can shorts predict returns? A global perspective"; In: The Review of Financial Studies; 35; Issue 5; May 2022
Boehmer, Ekkehart/Zsuzsa Huszar/Bradford Jordan (2010): “The good news in short interest”; In: Journal of Financial Economics; 96; Issue 1; April 2010
Chague, Fernando et al. (2023): “Why do individuals keep trading and losing?” November 7, 2023; Internet reference: SSRN – Social Sciences Research Network
Chen, Chen/Qiqi Liang/Licheng Sun (2023): “Swim with Sharks: Are short sellers more informed than their competitors?”; October 25, 2023; Internet reference: SSRN – Social Sciences Research Network
Chen, Yong/Zhi Da/Dayong Huang (2022): “Short selling efficiency”; In: Journal of Financial Economics; Vol.145; Issue 2; Part B; Aug 2022
Crabb, Gavin/Kaitlin Hendrix (2020): “Borrowing Fees and Expected Stock Returns”; Dimensional Fund Advisors; November 6, 2020; Internet reference: SSRN – Social Sciences Research Network
Diether, Karl/Kuan-Hui Lee/Ingrid Werner (2008): “Short-sale strategies and return predictability?” In: Review of Financial Studies; 22; No. 2; Feb 2009
Drechsler, Itamar/Qingyi Song Drechsler (2021): “The Shorting Premium and Asset Pricing Anomalies”; July 15, 2021; Internet reference: SSRN – Social Sciences Research Network
Gargano, Antonio (2021): “Short Selling Activity and Future Returns: Evidence from FinTech Data”; 16 Mar 2021; Internet reference: SSRN – Social Sciences Research Network
Gorbenko, Arseny (2023): “Short Interest and Aggregate Stock Returns: International Evidence”; In: The Review of Asset Pricing Studies; 13; Issue 4; Dec. 2023
Managed Funds Association (without author) (2022): “The Use of Short Selling to Achieve ESG Goals”; June 2022; Internet reference here
Nasdaq (no author) (2021): “The Predictiveness of Short Interest”; June 21, 2021; Internet reference here
Rapach, David/Matthew Ringgenberg/Guofu Zhou (2016): “Short interest and aggregate stock returns”; In: Journal of Financial Economics; 121; Issue 1; July 2016
Swedroe, Larry (2023): “New Evidence that Short Sellers Correct Overpriced Stocks”; In: Advisor Perspectives; March 20, 2023; Internet reference here