Why does high short interest indicate future underperformance of stocks? Does the reason suggest a way to refine the short interest signal? In their October 2007 paper entitled “Why Do Short Interest Levels Predict Stock Returns?”, Ekkehart Boehmer, Bilal Erturk and Sorin Sorescu employ two distinct methods to determine which of two hypotheses drives the underperformance of heavily shorted stocks: (1) constraints on short selling, or (2) superior private information of short sellers. These methods combine the level of short interest with the level of institutional holdings (supply of shares available for lending) and with earnings surprises. Using return, short interest, institutional ownership, earnings and related fundamental data for a broad sample of stocks over the period 1988-2005, they find that:
- Heavily shorted stocks underperform lightly shorted stocks by 1.51% (1.72%) per month on a raw (risk-adjusted) basis. The tenth of stocks that are most heavily shorted generate an average monthly risk-adjusted return of -0.52%.
- Stocks with increasing levels of institutional ownership have higher returns. Stocks with large increases in institutional ownership consistently have higher returns than those with small increases.
- Among the 20% of stocks that are most heavily shorted, a hedge portfolio that is long (short) the stocks with highest (lowest, most negative) changes in institutional ownership generates a raw average monthly return of 7.71% over the quarter in which the change occurs. Such hedge returns consistently increase with the level of short interest.
- A hedge portfolio that is long (short) lightly (heavily) shorted stocks generates a daily return of 0.31% during the four days around earning announcements.
- Among the 20% of stocks with the lowest institutional ownership, a hedge portfolio that is long (short) lightly (heavily) shorted stocks generates an abnormal return of 0.70% around earning announcements. This short interest predictive power increases consistently as institutional ownership declines.
- These results are consistent with the explanation that short sellers have superior information about firms that they reveal through their actions and not with the explanation that costs of short selling result in mispricing of stocks due to an imbalance between uninformed optimists and uninformed pessimists.
In summary, investors can concentrate the informed signals of short sellers by locating stocks with high short interest and low institutional ownership, and an increasing ratio of short interest to institutional ownership.
