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Opposing views

The likelihood of activist hedge funds targeting and making money is higher when large short sellers also target the same company, finds a new study co-authored by Dr Pedro Saffi of Cambridge Judge Business School.

The rather tatty frontage of a GameStop shop in Kokomo, Indiana.
A short squeeze of the stock of the American video game retailer GameStop in January 2021 caused major financial consequences for certain hedge funds and large losses for short sellers.
Pedro Saffi.
Dr Pedro Saffi

Activist hedge funds buy shares in underperforming firms and try to increase value through often noisy intervention or “voice”. Short sellers also target underperforming companies but with a different view to activists, in that they expect prices to decrease further. So how do these sophisticated groups with opposing perspectives interact in practice?

A new study co-authored by Pedro Saffi of Cambridge Judge Business School finds that the likelihood of activists targeting a company and the probability of a successful campaign in generating higher abnormal returns are greater when there are also large short sellers targeting the same company – especially when activists achieve their stated goals in addressing underperformance. The research shows further that the effect is even larger when investor disagreement on the firm’s future is higher.

“Corporate managers might be more likely to accept activists’ demands and implement their proposals” when a stock is targeted by both hedge funds and large short sellers, the study says. “This increases the probability of success as managers try to mitigate the negative effects of short selling on share price, which can affect managerial compensation and the ability of the firm to invest.”

Yet hedge fund activism does not affect the likelihood of a large short position, perhaps because of heightened “short-squeeze” risk that forces short sellers to cover their positions at unfavourable prices (thus making short selling less desirable) – as seen in the “long-short” battle earlier this year involving Texas-based gaming and electronics company GameStop.

The study is based on 648 activist campaigns in Europe between 2010 and 2019, which was merged with hand-collected data on 14,646 large short positions involving 1,648 stocks in Europe. Prompted by the 2008 financial crisis, the European Union required that short positions exceeding 0.5% of shares outstanding must be disclosed to the public after November 2012.

Another interesting finding of the study: there was an increase in activist campaigns in EU countries without disclosure requirements prior to November 2012 relative to the three EU countries (France, Spain and the UK) that did have such a requirement prior to November 2012, suggesting that “activist hedge funds pay attention to and learn from large short sellers’ disclosures,” the study says.

“The study’s findings are significant because they involve two of the most sophisticated types of investors in stock markets. Even more striking is the fact that they both analyse the same firm but reach very different conclusions about what its price should be,” says study co-author Pedro Saffi, University Lecturer in Finance at Cambridge Judge Business School. “Activist hedge funds and short sellers often ‘agree to disagree’, as shown by the dispute in recent years between Carl Icahn and William Ackman over nutritional supplements firm Herbalife.” The study – entitled “Power Grab: Activists, Short Sellers, and Disagreement” – is co-authored by Tao Li of the University of Florida, Pedro Saffi of Cambridge Judge Business School, and Daheng Yang of Columbia University.