Will The Short Interest Factor Ever Go Back To Normal?
We resume Factor Spotlight this week in the wake of the article published by Bloomberg this past Wednesday titled “The Hottest Hedge-Fund Strategy Faces an Existential Crisis”. This article posits that equity long-short strategies are no longer working and supports a conclusion that forecasts rough goings for the world’s most popular hedge fund strategy by pointing to weak performance, increased investment outflows, and fund closures since 2019 that have accelerated as COVID has impacted the markets.
Long-short equity managers are a vital part of the Omega Point community. This compels us to dig deeper into this “Long-short Existential Crisis” over the next several weeks using empirical data to impart insights that may benefit today’s long-short investment managers going forward.
Short Interest Factor - A Possible Culprit?
With the Nasdaq at all time highs and down days in the market short-lived, long-short managers are suffering on the short side as seemingly no bad news can hurt returns. Since hedge funds comprise a large portion of the borrowed shares in equities, this week we will take a look at short interest as represented by the short-interest factor, especially in light of a key question posed by the article “If the arrival of a deadly pandemic that’s pummeled the world’s economies can’t work in short-sellers’ favor, then what can?”
First we start with the factor return for Short Interest in the MSCI US Total Market Equity Trading Model. MSCI creates the Short Interest factor the ratio of shares borrowed for shorting to inventory available for lending. The more shares borrowed for shorting, theoretically the more downward pressure on an asset’s price.
Below we see the history of the factor return for Short Interest since December 2008.
The last 12 years have seen a downward trend with some intermittent positive spikes - most notably during the most recent time period.
The Short Interest factor YTD behaves like a completely different factor than what we saw in the longer term. It drifted slowly upwards in early 2020, but jumped upward when the Fed and Congress announced an unprecedented response to the COVID crisis. Interestingly, Short Interest was actually Overbought in late February, but instead of reverting to historical levels (as likely would have happened during a typical market), the stimulus caused this factor to jump further and land squarely in Extremely Overbought territory.
What Happened in 2008?
Although managers with short positions may be feeling the pain of the Fed’s monetary policy, the question remains how much longer negative returns can be suppressed. We rewind to the 2008 Financial Crisis, and see that during this time we also saw a large spike in the Short Interest factor, only to see it decay back to it’s longer term negative trend. The question remains - how much longer can the Fed suppress negative price discovery? History seems to suggest it’s only a matter of time...
While looking back to 2008 is helpful for our analysis, we must emphasize that we see much heavier retail flow driving the market today that we did in 2008. Over the coming weeks, we will be incorporating the impact of retail flows into our analysis along with other traditional and alternative datasets using a recently released feature of Omega Point that allows users to apply custom content sets into their analyses.
US & Global Market Summary
US Market: 6/29/20 - 7/10/20
- The market saw fairly consistent gains over the past two weeks, despite sobering news of 38 states seeing a rise in COVID cases during that same time. Some out-of-favor sectors like airlines, cruises, and energy rallied on Friday on renewed optimism about a COVID treatment.
- Troublingly, there has been a dramatic increase in applications for unemployment benefits through the federal emergency relief program (+53% in the past month). It remains to be seen if negative employment news has any impact on market returns going forward.
- Investors are now looking ahead to the start of earnings season next week, as well as reports on June retail sales and July consumer sentiment to better understand the state of the economy.
Factor Update: Axioma US Equity Risk Model (AXUS4-MH)
- Momentum surged over the past two weeks, gapping up from negative normalized returns to the brink of Oversold territory.
- Size also continued to rebound from being a deeply Oversold factor (-3 SD below the mean at the beginning of June).
- Profitability saw consistent gains during this time, exiting Oversold space with a +0.6 SD move.
- Value rapidly declined on a normalized basis, falling from Overbought to Neutral over the past two weeks.
- Volatility and Market Sensitivity both sold off on a normalized basis during this time, with Market Sensitivity heading deeper into Oversold territory.
- US Total Risk (using the Russell 3000 as proxy) declined by 47bps and remains elevated relative to Global risk.
Factor Update: Axioma Worldwide Equity Risk Model (AXWW4-MH)
- Similar to the US, Momentum was the biggest winner over the past two weeks as it shot up nearly +2 standard deviations from a trough of -3.13 SD below the mean on 6/10. It’s now on the cusp of becoming an Overbought factor.
- Earnings Yield saw strength on a normalized basis and now sits in Neutral territory.
- Size rallied by nearly a full standard deviation, and is currently heading towards Overbought territory for the first time since April.
- Market Sensitivity and Volatility both sold off on a normalized basis, with Market Sensitivity garnering an Oversold label.
- Global Risk (using the ACWI as proxy) fell by 30bps during this period.