Do changes in hedge fund holdings and short interest in a stock together predict its returns? In their January 2015 paper entitled “Short Selling Meets Hedge Fund 13F: An Anatomy of Informed Demand”, Yawen Jiao, Massimo Massa and Hong Zhang test whether joint changes in aggregate hedge fund holdings and short interest of a stock relate to its future returns. They define a contemporaneous increase (decrease) in aggregate hedge fund holdings and decrease (increase) in short interest as indicative of informed long (short) demand for a stock. They relate informed demand to abnormal return, the return of the stock relative to that of its style benchmark based on size, book-to-market and prior-period return. Using size/value characteristics, monthly returns, quarterly short interest and holdings from quarterly SEC Form 13F filings of 1,397 hedge funds for 5,357 U.S. stocks during 2000 through 2012, they find that:
- In-sample tests show that future abnormal returns relate positively (negatively) to informed long (short) demand.
- Out-of-sample portfolio tests based on quarterly rankings of stocks into fourths (quartiles) based on changes in hedge fund holdings and changes in short interest show that:
- The equally weighted stocks with the strongest informed long demands generate a gross quarterly abnormal return of 2.1% (8.8% annualized).
- A hedge portfolio that is long (short) the equally weighted stocks with the highest informed long (short) demands generates a gross quarterly abnormal return of 2.5% (10.5% annualized).
- Results for value-weighted portfolios are consistent.
- Hedge portfolio return predictability persists but fades over the 12 months after portfolio formation, with gross quarterly abnormal return of 2.5%, 2.0%, 0.7% and 0.5% during the first, second, third and fourth quarters after formation, respectively.
- Informed demand return predictability is more reliable for stocks with relatively large market capitalization, high turnover ratio, wide analyst coverage and high analyst dispersion.
- Informed demand also forecasts future firm fundamentals (return on assets and earnings surprises) and analyst earnings forecast revisions, suggesting that informed demand derives from superior understanding of firm fundamentals.
In summary, evidence indicates that investors can exploit the interaction of change in hedge fund stock holdings and change in short interest for the same stock, mostly on the long side.
Cautions regarding findings include:
- Returns are gross, not net. Accounting for the frictions of quarterly portfolio reformation and shorting costs for the hedge portfolio would reduce reported returns.
- The authors do not account for the substantial delay between the end of a quarter and availability of Form 13F data for that quarter, potentially overstating the level of exploitability. A hedge fund subject to the regulation must file a Form 13F “within 45 days of the end of a calendar quarter”. Persistence of effects beyond the first quarter mitigates this concern.
- The sample period is not long and intentionally excludes “the confounding effects associated with the tech-bubble period” as unrepresentative. This older excluded data may not be unrepresentative.
