Investors willing to risk betting against smaller companies may have found an edge this year.
“This is a more fertile ground for short-selling possibly,” Ihor Dusaniwsky, managing director of predictive analytics at S3 Partners, said in a phone interview Thursday. “The trades are a little bit less crowded and they might have a greater net return.”
At least, when short sellers find themselves on the right side of the bet.
Profitable short positions in stocks with smaller capitalizations in the U.S. have an average return of about 27% this year through April 20, while larger-cap shorts that made money gained an average 15%, according to Dusaniwsky.
Short sellers seek to profit by borrowing shares and then selling them on the belief their price will fall. If they turn out to be right, and the stock tumbles, short sellers make money by buying the shares back at a lower price and pocketing the difference when returning them to the lender.
But short selling is perilous, with the potential for losses unbounded when a bet goes wrong because the stock price soars instead. So far this year, investors wagering against smaller companies have experienced less pain compared to bets that shares of larger companies will fall, an S3 Partners report this weeks shows.
S3 calculated that larger-cap shorts were down 10.6% this year in mark-to-market losses after financing costs. By contrast, smaller-cap shorts were down 4%.
“It seems short sellers are getting more active” in smaller stocks, Dusaniwsky said.
His report cited some of the more profitable shorts in that category this year on a mark-to-market basis, including bets against FibroGen Inc.
Lordstown Motors Corp.
and Fisker Inc.
While potentially bigger gains in the smaller-cap landscape may be attracting small and mid-sized hedge fund managers, Dusaniwsky cautioned that “you’ve got liquidity issues” to consider that make it more expensive to short small, micro and nano sized companies.
The average annual borrowing cost to short smaller companies is 2.39%, more than six times higher than the average 0.38% for mega, large and mid-sized stocks, the S3 report shows.
The number of shorted small-cap stocks far exceeds bets against big companies, though the volume of short interest in large-caps is much bigger, according to S3 data.
Smaller companies tend to be more volatile, said Dusaniwsky, noting in his report that they have less daily trading “liquidity” relative to the amount of shares shorted. He cited the “increased risk of stock borrow recalls as the lack of overall supply reduces the chances of finding replacement stock if a beneficial owner sells the shares they are lending.”
Short sellers are up against a U.S. stock market that has touched record highs in 2021.
The Russell 2000 index
which tracks the performance of small-cap stocks, was up about 15% this year based on early afternoon trading Friday. That compares with 11% year-to-date returns for the S&P 500 index
around that same time, according to FactSet data.