Formula: Information + Liquidity + Short Time Horizon = Short Sales Profits
Jaewon Choi and two other scholars recently presented a paper that offers “direct evidence about the profitability of hedge fund short trades in equities.” What is intriguing about this paper is not only what it finds about the profitability of short trades, but its method, why its authors consider their evidence more “direct” than discussions already in the literature.
These scholars call their work “a first glimpse” at hedge fund shorting. This might bring some readers up short, so to speak. Hasn’t the field been much debated? Haven’t there been lots of “looks”?
Well … yes. But these authors consider their “look” the first “direct” examination of the matter because they identify the opening and covering of equity short sales with the help of a novel algorithm that combines data from different data sets and gets to the level of individual management companies.
Who are they? Choi is an assistant professor of Finance at the University of Illinois at Urbana-Champaign. Co-author Neil Pearson is a professor at the same institution, and Shastri Sandy, as associate at the Brattle Group, has a Masters of Engineering from Massachusetts Institute of Technology.
What are Their Findings?
Choi et al make the following findings:
Those points are closely related. For example, the reason institutional investors don’t make profits on their short positions is that they don’t play for liquidity providing function in the markets that hedge funds do, and so can’t (in effect) charge for doing so.
- Short sales concluded by hedge funds and covered within five trading days are highly profitable;
- If a short position remains uncovered for longer than that, it will likely prove unprofitable;
- Institutional (non-hedge-fund) investors tend to lose on their short positions, regardless of the time horizon;
- Some of the profitability of those quickly covered positions comes from an information edge, while another part comes from the provision of liquidity;
A Natural Experiment
How did these scholars determine that their algorithm is reliable? Ah, that is an intriguing subject for the methodological nerds who will surely read this paper. They know because of a natural experiment performed by the Securities and Exchange Commission during the global financial crisis.
On September 19, 2008, the SEC banned all short sales of certain listed stocks, a list designed to protect the financial services industry from predation. On October 9, the SEC allowed the resumption of short sales. Choi et al presumed that, if their algorithm worked properly, it should identify the quantity of short sales in the financial services industry’s issued stock as close to zero during that period. Indeed, when the algorithm is run it shows that the average dollar value of shares sold short plummeted close to zero exactly when one expects that it should. Thus, the algorithm was vindicated....MORE