Biotech Follow Up

Any new strategy should be forwarded-tested as long as possible. Forward-testing is simply paper trading or utilizing an insignificant amount of capital to test a strategies’ efficacy in real-life. Back testing is great but it’s certainly not fool-proof. As discussed in the previous post, many bio-tech traders are making money to the short side. If these traders are informed or have an edge perhaps we can follow along by monitoring the short-interest ratio. I think this is a reasonable hypothesis since shorting a stock can be quite dangerous and costly via the cost of borrow. And since many of these stocks are somewhat illiquid until an event, it can take awhile to establish a position and this will show up in monthly short interest reports. I did a quick search through SSRN and found a paper “Short Interest and Stock Returns” by Asquith, Pathak, & Ritter and in the conclusion I found the following:

the abnormal return for the 99th percentile EW portfolio is a significantly negative 125 basis points per month over the 1988-2002 period, and the abnormal return for the 95-98.9th percentile EW portfolio is a marginally significant 36 basis points per month. Therefore, following the advice to stay away from highly shorted stocks only requires investors to avoid a few percent of all stocks in the market each month, although diligence is required to track the changing composition of these stocks.
Our findings also have implications on whether hedge funds produce positive abnormal returns. A common assertion is that one way that hedge funds add value is because of their ability to take short positions in overvalued equities, whereas most mutual funds are restricted to long-only positions. Our results indicate that the only class of stocks that reliably produce negative abnormal returns is that of small cap firms with extremely high short interest ratios.

Here EW = equal weight. So high short interest shows negative abnormal returns and is most pronounced in small cap stocks. Good news since most bio-tech, especially early stage companies, are small/micro cap stocks. So I put together am equal weighted portfolio of the top 20 biotech stocks by short interest ratio:

The portfolio was created using closing prices from 8/13/10. We’ll check back in a few months and see how well it does!

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~ by largecaptrader on August 17, 2010.

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