With our financial markets riveted lately by the action in GameStop (GME), attention has been turned to evil short sellers and getting shorty, which is natural. The action in GME was made more compelling by the breathless reporting in the media that it was so heavily shorted, with more than 100% of its float short, as if that were an issue (it wasn’t and it isn’t).
You know why investors get involved in heavily shorted names, and keep shorting them?
Because it works.
From March 2008 through March 2020 the most expensive-to-borrow US equities (high-fee) underperformed the least expensive-to-borrow shares (low-fee) by an average of 1.3% per month. This past year was the first time in a long time that the “most-shorted” basket outperformed the low-cost basket. January 2021 was the worst month in history for the most-heavily-shorted stock factor. And it hasn’t just been January. As you can see in the chart below, due to substantial outperformance of high-fee shares in April and June 2020, the rolling 12 month average spread in the return between high and low fee shares turned positive and has remained there since.
Including the month-to-date return (MTD) through January 28th 2021, the highest fee US equities have outperformed by 2.6% per month on average over the past 12 months. This most recent rolling 12-month period is the only instance in the last 15 years when shorting the most shorted basket has hurt, as you can see. In every other rolling 12-month period, you were rewarded by shorting the most shorted basket. Gee, what’s happened in the last twelve months that would change things?
According to IHS Markit, the most heavily shorted firms outperformed the least shorted by 23.9% MTD through January 28th. The nearest competition for “worst month for short factors” consists of April 2009 when the most shorted outperformed by 15%, and April 2020 when most shorted outperformed by 21%. Ranking by the percentage of shares on loan yields a similar result for January, with most-borrowed outperforming by 23.6% MTD. This is record outperformance, never seen before. And I’ve got a secret for you: it isn’t just GME and AMC. If both GME and AMC were removed from the analysis, the relative outperformance of high-fee US equities would still be more than 25% for January 2021 as compared with the lowest-fee shares, according to IHS Markit.
“GameStop” and “short squeeze” are now inextricably linked in market lore. GME was at $19 on Jan 12th, $31 on Jan 13th, $43 on Jan 21st, and $347 on Jan 27th. According to IHS Markit, the 5.6 million reduction in shares on loan tied to settling trading from January 13th had only declined slightly in reaction to this first large single day increase in GME’s price, suggesting short covering wasn’t that big of a catalyst. In other words, the majority of the short position in GME remained in place as of Jan 15th.
The number of GME shares on loan declined by another 19 million from January 22nd to the 28th, suggesting that a larger portion of the short position was covered amid the surging share price during that week, but that still wasn’t the sole catalyst. It is worth pointing out that total short interest (or shares on loan) for GME was only a tiny fraction of the traded volume during this time. Clearly, short covering in GME had AN impact at specific points in time, but short covering (as usual) can only go so far in explaining the sharp jump in price in shares.
This wasn’t a stick-it-to-the-man-short-squeeze-David-vs.-Goliath move. Not even close. It was the man, in the form of a mid-sized hedge fund and institution, jumping on the momentum train and flipping shares to unsuspecting retail who performed perfectly its historic role as the dumb buyer of last resort. Congratulations to Reddit.
Wait, it gets better. Again from IHS Market: “The supply of shares from beneficial owners in securities lending programs can be tracked as a real-time indication of availability from institutional owners of shares, while the gap between the exchange short interest and borrowed shares provides an indication of shares sourced by broker dealers away from the traditional securities finance channel.” In other words, as institutions sold into the insane rally, they called their shares back from stock loan and the gap was made up from retail brokers and retail customers supplying shares into the short. I.e., buying at the top. Thanks Reddit! Thanks unsuspecting retail buyers!
AMC was a different animal altogether and its wild trading swings were tied mostly to convert hedging. The process of hedging a long position in a convertible bond, when the common share price is increasing, involves shorting an increasing number of shares as the delta of the embedded call option approaches one. While that looks like short sellers are “fighting the tape” by shorting more shares as the price increases, it’s not. The price of the convertible bond may be increasing by more than the delta-adjusted hedge, delivering a profit to the holder, so the shorting of shares is less relevant to the convert holder, who is booking larger profits on the long bond position.
There WAS a tightening of the borrow in AMC on September 14th, 2020 after a reset provision was triggered for the outstanding convertible bond, which increased the number of shares each bond was convertible into, suggesting (to me at least) convertible hedging was a meaningful factor for short positioning in AMC. IHS Markit: “The impact of convertible hedging may have recently increased amid the surge higher in share price, which would help to explain the increase in share borrowing despite what would appear to be a face-melting short squeeze.” In other words, “My convert went up more than the stock, so I’m good.”
DDD, the 3-D printing company, is another example of when short covering may be a catalyst, but not the primary or lasting catalyst. On January 7th 2021, shares on loan in DDD declined by 14.8 million shares (out of 197 million shares of traded volume that day). But DDD’s share price had increased by another 65% since January 7th, with only a five million share reduction in borrowing, suggesting that short covering has had rather minimal impact on the trend higher after the initial squeeze. You go Retail!
Back to our original point: the academic research on the outperformance of shorting the most expensive basket is deep and compelling. Here are a few snippets from just two papers, which show, among other things, that on average the most shorted basket has outperformed by 1.3% gross PER MONTH.
And it’s only the most shorted basket that works like this. Shorting the average stock is pointless, or at least it has been for the past 15 years. That is a more of a comment on the trend in markets toward passive investing than anything as price discovery and fraud detection go by the wayside in a passive strategy. You might like your passive ETF, but it is going to buy every name on its list, whether the company is headed for trouble or not.
While populist politicians like to make villains of short sellers, healthy markets need short sellers (and good regulation). As renowned finance professor Merton Miller explained a long time ago, doing away with shorting results in. . . overpriced securities.
This academic research surrounding the efficacy in shorting the most expensive and most popular short names also looks at the returns from companies that actively try and fight back against shorts. And it shows that firms that put up the biggest fight against short sellers perform even worse than the average highly shorted name.
We read the financial news like everyone else, and the amount of populist lore and outright fiction is astounding. For one, it is near impossible to get away with “naked shorting” (shorting a stock for which one has not borrowed before executing one’s short sale) over a prolonged period of time. Yes, it certainly happens anecdotally, but in a small scale. Naked shorting mostly occurs around day trading, where positions are closed by end of day, and any reputable prime broker will police the activities of its clients and if it finds a short seller violating the borrow rules, it should (and most likely does) clamp down on said short seller, even kicking them off their platforms as an outcome.
But shorting was never the issue in GME (or even AMC). What drove those stocks to stratospheric heights were buyers – ignorant buyers blindly speculating, but buyers nonetheless. How does one police stupidity? And the reason Robinhood and other platforms restricted trading in GME and other names was not because short sellers were mucking around in markets. No, it was because Robinhood lost control of its back office a little bit. Maybe instead of casting aspersions at short sellers, the press should look to the real trouble for blame: a dumb trading toy that puts its customers second and sells their order flow to others while also not spending money on back office and clearing capabilities.
The fact remains, short selling provides an important balance to market efficiency. Moreso, in spite of it being at times a perilous and difficult task, it can also be extremely profitable and, done properly, can provide good returns to investors like those of you reading this post. So, in this day of Alice in Wonderland, where up is down and down is up, there answer isn’t “Get Shorty.” But rather, get short, preferably a high-cost basket of names.