Short sellers bet on their conviction that a particular asset’s price will fall. They borrow shares and sell them in the market, hoping to buy them back later at a lower price to pocket a profit from the price difference. Dedicated short-bias hedge funds are investment funds that primarily focus on this short-selling strategy, aiming to profit from declining stock prices. However, a series of challenges have pushed these hedge funds to the brink of extinction – and that has important implications for the market and investors.
Why are short sellers in retreat?
A good question, and one with plenty of answers.
First, betting against stocks has increasingly become a losing strategy. The market value of the S&P 500 has more than doubled over the past decade, picking up by about $30 trillion on the back of ultra-low interest rates and the recent AI-fueled frenzy. Needless to say, a strong rally that lifts all stocks can be very dangerous for short sellers. That’s because the strategy theoretically faces the potential for unlimited losses since there’s no limit to how high a shorted stock’s price can rise.
The S&P 500’s market capitalization has surged by about $30 trillion in the past decade. Source: Bloomberg.
Second, it has become more expensive to borrow shares in some corners of the market. For example, Acadian Asset Management has routinely seen annualized shorting costs above 100% for hundreds of individual US stocks this year. And occasionally, it’s spotted shares with costs above 1,000%. We haven’t seen anything like this since 1931, according to Acadian. Turning from the extreme cases to the whole market, the firm found that both the mean and median cost of shorting have steadily increased over the past two decades, especially for small-cap stocks.
Third, short sellers have been burned by market frenzies. The meme-stock saga of 2021 saw groups of retail traders coordinating on social media and online forums to drive up the prices of heavily shorted stocks such as GameStop and AMC Entertainment. Their actions led to massive short squeezes, forcing the institutional investors and hedge funds that had bet against these stocks to buy them back to cover their positions. After incurring huge losses in the process, many short sellers exited the market altogether.
Fourth, regulators have been coming down increasingly hard on the strategy of betting against stocks. In 2021, it emerged that many activist short sellers were under investigation by the US Justice Department and Securities and Exchange Commission (SEC) for potential market manipulation. Now, no charges were ever brought. But last year, the SEC finalized rules requiring hedge funds and other big investors to report their short positions in certain stocks every month. That move toward transparency reflects the widespread suspicion surrounding traders who seek to profit from declines. After all, they have long drawn the ire of the companies they target, investors in those stocks, and the financial establishment.
Just how bad is the retreat?
Assets under management in funds with a short bias – essentially, those betting on falling prices – have slumped from $7.8 billion in 2008 to $4.6 billion today, according to Hedge Fund Research (HFR). In contrast, equity hedge funds as a whole have seen their assets nearly triple over the same period. Plus, while HFR’s short-bias hedge fund index boasted 54 members in 2008, that’s been reduced to just 14 today, with many funds shutting down after years of losses and outflows.
Here’s another interesting stat: short interest, or the number of shares sold short expressed as a percentage of the total number of shares outstanding, in US stocks has plummeted. According to Goldman Sachs, the median short interest in S&P 500 companies is hovering around the lowest levels in more than two decades, and is below the long-term average in every major sector.
US stocks’ short interest is hovering near a two-decade low. Source: Bloomberg.
Finally, the number of activist short campaigns – where investors seek company flaws and bet against them before making their findings public – launched in 2022 was the lowest in a decade, with only a tiny uptick last year.
What are the market implications?
Love them or hate them, short sellers play an important role in keeping markets efficient. By borrowing and selling shares they perceive as overpriced, they help prevent excessive valuations in individual stocks and, by extension, the wider market. What’s more, short sellers often uncover accounting shenanigans, fraud, and other bad corporate behavior in the firms they bet against, bringing these issues to public attention after they’ve made their bets. Just look at legendary short seller Jim Chanos, who helped reveal the accounting fraud that was taking place at Enron – the energy trader that collapsed in 2001.
So with fewer cases of investing vigilantism, the market loses some of its checks and balances. And that can potentially lead to inflated stock prices and more corporate misconduct. That means those who continue to short stocks may face greater volatility and unpredictability – but they also stand to make even bigger gains if their bets against overvalued or mismanaged companies prove correct. In other words, with short sellers in retreat, betting against stocks offers the potential for higher returns, but with higher risk.
In fact, it’s a funny fact of investing that when a particular strategy is proclaimed dead, that’s often a contrarian indicator that it’s about to start working. Chanos says the current downturn, which he reckons has been running for 15 years, is part of a cycle – similar to what was seen in the build-up to the dot-com bubble. And the longer the cycle lasts, the more short selling seems to be questioned and falls out of favor. But that’s generally right before it’s made a lot of money for investors.
If you think Chanos is correct but don’t know where to start, consider exploring two areas he recently highlighted as attractive opportunities for short sellers. In a June interview with Bloomberg, the legendary investor pointed out that residential solar stocks are burning millions of dollars each quarter. He also said that legacy data centers risk falling behind, as their older infrastructure potentially proves to be mismatched with newer, AI-focused technologies.