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Cohen, Diether, and Malloy, 2007; Boehmer, Jones, and Zhang, 2008; Boehmer, Huszar, and Jordan, 2010; Saffi and Sigurdsson, 2011; Hirshleifer, Teoh, and Yu, 2011; Ak- bas, Boehmer, Erturk, Sorescu, 2013; Boehmer and Wu, 2013). The question of whether managers are informed and whether they can deliver superior performance is also at the core of the analysis of the hedge fund industry (e.g., Fung and Hsieh, 1997; Ackermann, McEnally, and Raven- scraft, 1999; Agarwal and Naik, 2004; Getmansky, Lo, and Makarov, 2004; Kosowski, Naik, and Teo, 2007; Agarwal, Daniel, and Naik, 2009, 2011; Aragon and Nanda, 2012; Sun, Wang, and Zheng, 2012; and Cao, Chen, Liang, and Lo, 2013, just to name a few).
However, a joint analysis of hedge funds and short selling—for instance, regarding changes in both hedge fund holdings and short interest—is lacking in the literature. This inattention is surprising because joint information is needed in many situations to understand motivations for hedge fund trading. Consider, for instance, the case in which aggregate hedge fund ownership of a specific stock increases. While such a “net buy” may be driven by pri- vate information that predicts positive changes in stock prices, it may also arise because of hedging—e.g., hedge fund managers use the long position to hedge the sys- tematic risk of their arbitrage strategy. It is not surprising, therefore, that changes in hedge fund ownership have not been found to be informative ex ante (e.g., Griffin and Xu, 2009), which may simply reflect the prevalence of the sec- ond (hedging) effect. In the presence of both hedging and information-driven trading motivations, therefore, assess- ments of the informational content of hedge fund trading can hardly be complete if we focus only on one class of trades.
In this paper, we bridge this gap by proposing a novel approach that jointly considers short selling and hedge fund holdings to differentiate between various trading mo- tivations. Returning to the previous example, if short in- terest decreases over the same period in which aggregate hedge fund ownership increases, hedge funds as a whole are likely to trade on a positive signal, which we refer to as informed long demand. When the opposite trading pattern occurs, i.e., when short interest increases over the same pe- riod in which hedge fund ownership decreases, the trading reflects informed short demand. By contrast, a simultaneous increase (decrease) in both short interest and hedge fund ownership may occur when hedge funds use both the long and the short sides to form arbitrage portfolios (or to un- wind existing arbitrage positions), which we can loosely refer to as hedging (unwinding) demand.2 Given that the direction of the signals for hedging/unwinding demand can- not be easily identified ex ante, it is critical to focus on informed long/short demand to properly assess the informa- tiveness of hedge fund trading.
This novel identification strategy allows us to shed new light on the informational content of hedge fund trading
2 Alternatively, one can also view the long side and short side of trad- ing as coming from two different groups of traders and interpret hedging demand as a situation in which the two groups have different opinions regarding expected stock returns. The interpretation of our main results, however, remains the same.
using information from both hedge fund 13F filings and short selling information for the complete list of U.S. stocks for the period from 2000 to 2012. Because we observe only aggregate information regarding short selling activi- ties for each stock (rather than how each hedge fund con- ducts short selling), we aggregate hedge fund ownership at the stock level, so that the two sides of information can be used jointly to infer informed demand at the stock level. We proceed in three steps.
In the first step, we examine the predictive power of informed demand for out-of-sample abnormal returns. We find strong evidence that informed long (short) demand is associated with positive (negative) out-of-sample abnormal stock returns, suggesting that such demand is indeed infor- mative. The economic magnitude is sizable. For instance, if we define informed long (short) demand as a dummy variable that takes a value of one when changes in short interest and hedge fund holdings belong to the most pos- itive (negative) quintiles of stocks in the same period, we find that this proxy is related to a 6.6% (−3.2%) annual- ized abnormal return in the next quarter under the tradi- tional Fama-MacBeth specifications. In other words, stocks characterized by informed long demand outperform stocks characterized by informed short demand by as much as 9.8% per year. If we directly construct portfolios, rebal- anced at quarterly frequency, that buy/sell stocks with the top 20% informed long/short demand, the abnormal return over the entire sample period is approximately 10.5% per year. This magnitude is on par with that obtained in the regression analysis.
We further confirm that return predictability identified in this way is not affected by the value premium, the size premium, or momentum. Neither is it spuriously gener- ated by various more recently documented anomalies as- sociated with the ratio of gross profit to assets (Novy- Marx, 2013), operating profit (Fama and French, 2015), as- set growth (Cooper, Gulen, and Schill, 2008), investment growth (Hou, Xue, and Zhang, 2015), net stock issuance (Xing, 2008), accruals (Fama and French, 2008), and the logarithm of net operating assets (Hirshleifer, Hou, Teoh, and Zhang, 2004). Rather, the return predictability of in- formed demand appears to arise from very different eco- nomic considerations than known asset pricing anomalies.3
In the second step, therefore, we investigate poten- tial economic channels through which informed demand achieves its predictive power. For this purpose, we first split the sample into two subgroups based on a list of firm characteristics, including market capitalization, turnover ratio, analyst coverage, and dispersion of analyst fore- casts. We then perform the return predictability test for
3 Our results are also robust to the use of different cutoff points for the definition of positive (negative) short interest and hedge fund holding changes, the use of different out-of-sample windows, and the inclusion of controls for hedging (unwinding) demand. In addition, placebo tests show that hedging and unwinding demands, unlike informed demand, do not exhibit consistent predictive power for returns, especially over a one-year horizon—and asset pricing anomalies absorb the remaining sig- nificance. Finally, we observe that, consistent with Griffin and Xu (2009), hedge fund holding information alone has insignificant return predictive power, which further confirms the empirical importance of combining hedge fund information with short selling information.
Y. Jiao et al./Journal of Financial Economics 122 (2016) 544–567 545

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