The FAANG stocks are five of the top ten most shorted stocks in the domestic U.S. stock market and because of the sheer size of combined short exposure they represent both risk “Alpha” trades and hedging “Beta” trades.
Total short interest in the FAANG stocks is $30.8 billion and has ranged between $28 billion to $40 billion in 2018, but after reaching a high of $40.3 billion in mid-March when Apple short interest shot up to $12.9 billion, combined FAANG short interest has been declining over the last three quarters. The decline in combined short interest is surprising as short exposure increased when the U.S. market was rallying and decreased when the U.S. market declined.
While a portion of FAANG short interest was an Alpha play, a significant amount of the outstanding short exposure was a Beta portfolio hedge – a relatively inexpensive way to protect the long part of a portfolio against a market downturn. With the five FAANG stocks in virtually every broad based and technology related index, ETF, and fund, short sellers were hoping for short exposure that outperformed on the downside as long shareholders and portfolio managers would be forced to sell off large chunks of FAANG stocks when fund and ETF instruments sold off on market weakness.
Although the FAANG stocks did outperform on the downside, they outperformed to a much greater degree on the upside. During the first half of 2018, with the S&P up 1.67% and the Nasdaq up 8.79%, FAANG stocks rose by 35.08%. In the second half of 2018, the S&P was down 3.00% and the Nasdaq was down 6.37%, but FAANG stocks “only” decreased by 14.98%. By “outperforming” on the upside and “underperforming” on the downside FAANG shorts lost much more when markets were up then what they made when markets were down.
While portfolio managers who used the FAANG stocks as a hedge for the long side of their book had good intentions, the results were less than optimal. As the markets rallied, their FAANG hedges took an outsized bite out of their Alpha and as the markets slumped, their FAANG hedges added less than expected to their bottom line. After this year’s performance, we may see an increase in ETF hedging activity, back to levels we saw in the first quarter of 2018.
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Managing Director Predictive Analytics, S3 Partners, LLC
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