Do anomaly portfolios that are long (short) the tenth, or decile, of stocks with the highest (lowest) expected value-weighted returns based on some firm accounting variable or stock behavior really work on a net basis? In the May 2019 version of their paper entitled “Shorting Costs and Profitability of Long-Short Strategies”, Dongcheol Kim and Byeung Joo Lee examine profitability of such portfolios after adjusting for: (1) unavailability of stocks to borrow for shorting as indicated; and, (2) stock loan fees paid to share lenders. They consider 14 value-weighted anomalies based on: return on assets, return on equity (ROE), momentum, net operating assets, investment-to-asset ratio, abnormal capital investment, accruals, asset growth, net stock issuance, composite equity issues, O-score, failure probability, gross profit and post-earnings announcement drift. They do not consider trading frictions (broker fees, bid-ask spread, impact of trading) incurred due to periodic reformation of anomaly portfolios. Using monthly stock prices and returns, data to construct value-weighted long-short anomaly portfolios, and share loan availability and fee data from Markit for a broad sample of U.S. stocks priced at least $1 during January 2006 through December 2017, they find that:
- Average gross monthly return of the 14 long-short anomaly portfolios is 0.262%.
- Average monthly shorting costs across anomalies are 0.029% and 0.075% for the two sources listed above, respectively. The total monthly shorting cost of 0.104% is about 40% of average gross anomaly monthly return.
- Shorting costs represent about 25% of widely used 3-factor model (adjusting for market, size and book-to-market factors) alpha and 80% of a 4-factor model (adjusting for market, size, investment-to-asset ratio and ROE) alpha.
- Incorporation of trading frictions for periodic reformation of anomaly portfolios would further reduce profitability.
In summary, evidence from actual shorting costs/constraints undermines belief in net profitability of long-short stock anomaly strategies.
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