This is the second post in a series describing the performance and effects of short selling. Part 1 dealt with three main effects: return to the underlying instrument, volatility slippage and the impact of the risk free rate. In this part we look at three lesser effects: borrowing fee, the deviation in financing from the risk free rate and management fee for the ETFs. In the end we’ll look at a real life examples from the recent past.
Fig. 2.1. A summary of effects impacting a long and a short position
4) Borrowing fee
Short selling is a strategy of selling financial instruments that we do not own. Therefore, before entering the transaction an investor needs to borrow the securities intended for future sale. For stocks and ETFs this comes at a fee; there’s no borrowing fee when short selling via futures. There are two main types of securities: easy-to-borrow and hard-to-borrow. The easy-to-borrow come with a very low borrowing fee: as low as 0.25% annually. On the other hand, the hard-to-borrow stocks and ETFs come with progressively higher, sometimes exorbitant fees, as high as several hundred percent annually. The following figure presents the distribution of borrowing fees for all securities available for shorting at Interactive Brokers on 19th of April 2023. About 6000 of them come with the very low borrowing fee of 0.25-0.30% annually. Another ~4000 securities have relatively low fees, up to current risk free rate of 5%. The remainder of securities gets progressively harder to borrow and, in effect, is characterized by very high borrowing fees. The fee can change daily and is subject to the usual forces of supply and demand. Please note the logarithmic scale on the y axis.
Fig. 2.2 Borrowing fees for short sale of US securities on Apr 19, 2023.
5) Deviation from Rf rate in financing
So far we have learned that shorting comes with a fee to the rightful owner of securities and the proceeds from sale can be invested at a risk-free rate. However in between you, the short seller, and the investor on the other side, there are intermediaries – brokers. They need to get their share of profits for facilitating the exchange between investors. Fig. 2.3 presents the yields from short sale of stocks/ETFs for Interactive Brokers investors. Benchmark rate is the risk free rate (at the time of writing: 4.83%). Short positions valued at less than $100k do not receive any proceeds from short sales. Larger positions, between $100k and $1M get 3.58%, as IBKR cuts its 1.25% fee. Only above the $1M the broker financing fees become rather small at 0.25%-0.5%.
Fig. 2.3 Interest paid for proceeds from a short sale at Interactive Brokers (Apr 19, 2023)
How about the futures? Here the situation looks more positive for the short sellers. As brokers do not need to locate & borrow shares and do not need to deal with position financing, no fee to brokers, other than the commission to open or close position, is necessary. In addition, there can be some discrepancy of financing “hidden” in the price of futures. Let’s look at an example of S&P 500 futures. Theoretically the price of futures vs the underlying index should reflect just the risk free rate and the impact of dividend payments. However, in practice, the price of futures is usually somewhat higher than theoretically expected. This is good news for short sellers, as the price needs to converge to index at expiry date, allowing for slightly higher realized returns. How much is the effect worth? In the 10 years following the GFC the so-called Futures Implied Rate was 0.30% annually on average, although it was nearly twice as high during the crisis itself:
Fig 2.4 Futures Implied Rate for S&P 500 futures
In summary, the deviation from theoretical financing fees is negative for stocks/ETFs due to the broker’s fee and amounts to between 0.25% and 1+% even for relatively large sizes for a retail or semi-professional investor – at a broker known for relatively low fees. The deviation can be positive when shorting via futures, but it will vary in time and for different instruments.
6) Management fee
This effect exists only for the ETFs, as there are no management fees for futures and individual stocks. High management fees are a negative for investors holding long position. But can an investor on the short side take advantage of the high management fee and pocket the profit? Let’s see. The following table lists 10 ETFs with the highest total expense ratio, taken from an article in etfdb.com. In the rightmost column I added the borrowing fee for each of the ETFs for the date of 19th of April. In all cases except two, the borrowing fee is higher than the total expense ratio. It means that one usually cannot expect to capitalize on the recovery of expense ratio via shorting. However, it is important to factor in both effects when calculating the expected returns of shorting ETFs.
Fig. 2.5 Borrowing fee for the ETFs with higher Total Expense Ratio.
REAL LIFE EXAMPLES
Ok, now it is time to put all the effects together. Let’s look at the theoretical and real performance of the ProShares Short S&P500 ETF (SH) between Dec 31, 2021 and March 31, 2023. This period of five quarters was characterized by a relatively weak performance of the index, making short selling a profitable strategy. The relevant data are as follows: S&P 500 had a Total Return of negative 11.97%, with annualized volatility of 22.95%. The cumulative return on 3M T-Bills was 3.27% and the management fee charged against the ETF assets was 0.89% p.a.:
Fig 2.5 Simulated vs. real return for SH ETF (Dec 31, 2021 – Mar 31, 2023)
The simulated return for the period was 11.18%, while the actual return for SH ETF in the same period was 0.18pp higher at 11.36%. The small discrepancy may be coming from several areas: the ETF uses total return swaps instead of futures and invests in T-Bills with a maturity both longer and shorter than the simulated 3 months. I also assumed that effect 5) was as equal to its average during 2009-2019, but did not independently check the actual value for the period.
Now, lets look at another real-life example for the same time period: shorting a 7-10 year Treasury bond index via the ProShares Short 7-10 Year Treasury ETF (TBX). As a basis for the analysis we’ll use the iShares 7-10 Year Treasury Bond ETF (IEF). It returned a negative 12.31% over the 5 quarters, but 0.16pp of that was the effect of the 0.15% management fee. Volatility was 10.4% annually. Let’s again use the 3 month T-bills as a proxy for the risk free rate not assuming any adjustments to position financing. We deduct the 0.96% management fee the ETF is charging on its assets.
Fig 2.6 Simulated vs. real return for TBX ETF (Dec 31, 2021 – Mar 31, 2023)
As we see, the simulated performance matched the real result exactly. We can notice that the performance of the short ETF (TBX) is substantially higher than just the reverse of long ETF (-IEF). IEF returned -12.31% in the analyzed period, while TBX returned 16.12%. The reason is that the volatility slippage was substantially lower than the effect of receiving the double of the risk free rate, just -1.36% compared to +6.53%.
SUMMARY & CONCLUSIONS
Contrary to a naïve understanding, short selling is a strategy that can perform well not only in the falling markets, but also when markets are flat or (slightly!) advancing. There are at least 6 effects that may impact the total return of the short selling strategy. On top of the obvious one, the change in the underlying instrument, the two other large effects are the volatility slippage and the effect of adding the double of the risk free rate. In recent times, the high level of risk free rate, approaching and exceeding 5% p.a. allows for 10+% short selling returns p.a. even in relatively flat markets. However, this positive effect can be substantially diminished in rebalanced portfolios when shorting instruments with high volatility due to the so-called volatility slippage.
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