Short Selling Strategy

Short selling is an operation consisting of selling a borrowed financial instrument with the intention to buy it back later. In doing so, an investor expects a fall of the price of a financial instrument. The short selling strategy is very popular in the hedge fund industry.

Short sellers have a negative exposition to the market in the sense that their beta is negative and could be greater than 1 in absolute value. Because of this exposure, the return of those hedge funds tends to be lower than the ones of other hedge fund strategies.

During the period 1994–2005, an amount of $10 0 invested in an average short seller hedge fund at the beginning of 1994 would have been slightly under $100 at the end of 2005 while the same amount invested in the S&P 500 index would have returned about $250 in 2005.

This proves that short sellers underperform over the long-term and seems to be a chronic problem for this strategy. Their returns are also much more volatile and a source of additional risk than those of the average hedge fund strategy given by a weighted composite index.

The performance of short sellers was effectively disappointing over the period 1994–2005. Hence, what are the benefits of short selling? There are four benefits of short selling:
  1. short selling contributes to market efficiency by conveying negative information to the market;
  2. it is the first line of defense against financial fraud or unjustified bubbles;
  3. short selling facilitates dealer liquidity provision; and
  4. short selling facilitates the implementation of several arbitrage strategies.
We must not also forget that short selling is an essential part of hedging activities.

Even if the mean return of short sellers is low, their Jensen’s alpha may yet be high when accounting for the risk factors proposed by Fama and French (1992) and correcting for the eventual specification errors, which may contaminate the Fama and French model.

Besides, short selling is generally viewed as a very risky strategy because the investors are used to buy and not to short sell. Short selling may also be accompanied by leverage operations, which might greatly increase the risk of the investments lying on expectations of falling prices.

Short Selling Strategy
Short Selling Strategy