To sell a stock short, you first need to borrow it from someone. The way that this happens is that your broker takes it from another client’s account and loans it to you. You can then sell it to someone else. This process has the fun consequence that the same stock can be shorted many times. The person who bought it from you can then lend it to someone else who wants to short and so on. This is also a reason that short squeezes can be so vicious. One person needing to cover their short position can set off a chain reaction.

But usually when there is a large interest in selling a certain stock short it will become hard to borrow. Not every stockholder lets their stocks be loaned to short sellers. When this happens, brokerages then charge higher fees. The borrowing rate is just the price of acquiring the loan, so it is driven by supply and demand like any other price. It might seem that high shorting fees are predictive of future stock returns as they arise from the fact that there are large bets being made on the stock dropping. But is this true? It doesn’t have to be. There are plenty of situations where fading big placements are successful.

Short interest as a predictor of future stock returns was studied by Itamar Drechsler and Qingyi Drechsler in the paper, “The Shorting Premium and Asset Pricing Anomalies”. At the end of each month, they sort stocks into equally weighted deciles based on the shorting fee and then look at average future performance of the deciles.

Using data from 2004 through to 2012 they found that:

• There is a relationship between shorting fees and subsequent returns, but it is decidedly non-linear. The effect mainly appears in the 20% of stocks with abnormally high fees.
• Average gross next month returns are about the same for the bottom eight deciles (in the range of 0.74% to 0.92 %) but the ninth decile is 0.52% and the highest decile (the ones with highest shorting costs) are negative 0.71%.
• Even after accounting for all of the interest costs, a portfolio that is long the lowest decile and short the highest decile returns 0.92% a month.
• They perform a similar analysis using estimated shorting fees going back to 1980. The results were similar (although I would trust this conclusion a lot less).

Using in house data, we have broadly confirmed these results from 2012 although the returns have diminished (typical of every strategy once it has been published. Another thing to be aware of is that the short rate market is not centralized, and the rates can vary wildly between brokers. This isn’t normally an issue, but when it comes to the extreme cases that drive this effect, it can be.

In conclusion, broadly speaking, stocks with high borrowing fees perform badly. Even long only investors can benefit just by avoiding these.

Disclaimer

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Except where otherwise indicated, the information contained in this article is based on matters as they exist as of the date of preparation of such material and not as of the date of distribution of any future date. Recipients should not rely on this material in making any future investment decision.