This paper investigates the short-side anomaly trading behavior of alternative mutual funds (AMFs) based on their short positions in US domestic equities. In aggregate, AMFs demonstrate the ability to exploit well-documented stock market anomalies on the short side, and the overpriced stocks sold short by AMFs generate significant negative alpha. Further, AMFs’ short side trades exhibit significant return predictability, which can at least partially derive from their ability to process public information on firm and anomaly characteristics. Finally, AMFs’ short side anomaly-based trading activity and profitability appear to be more pronounced among the stocks with higher credit risk or dynamic short selling risk.
Using the actual short positions of a sample of US equity-focused AMFs from Morningstar during 2002–2019, researchers first investigate whether AMFs trade on the short side to exploit the nine well-documented stock market anomalies and, if so, whether AMFs’ short-side anomaly-based trading generates abnormal performance.
Researchers found that AMFs trade in the “right” direction as implied by anomalies on the short side by short-selling overpriced stocks and short-covering underpriced counterparts, and that the overpriced stocks sold short by AMFs generate significant negative alpha. We also show that AMFs in aggregate have strong preferences for small, growth (large, value) stocks with high (low) liquidity and idiosyncratic volatility in their short-selling (short-covering) decisions.
Further, AMFs’ short-side trades, in general, can predict future stock returns up to two quarters and this predictability largely derives from their ability to process and analyze public information related to firm size and market anomalies.
Finally, AMFs tend to trade more aggressively on market anomalies on the short side and the abnormal returns generated from short-side anomaly-based trading are more pronounced among the stocks with higher credit risk or dynamic short-selling risk.