We’ve talked in the past about how the methodology of short selling works, and also how the rules for trading, holding, and reporting work. However, many misconceptions remain about Why Companies see fluctuations in their short interest.
Now, we’ll talk about the interesting dynamics in today’s markets between short interest and index inclusion.
At first, these two seem unrelated – one about idle flows and benchmarking, and the other with market efficiency – but when you look at the data, some patterns emerge.
Index membership brings new passive demand and new hedging activity
It’s no secret that inclusion in an index is good for companies; This means index funds will buy and hold your stock for the long term and active funds will have to decide if they want to hold your stock at a lower weight.
This results in exchange-traded funds (ETFs) and sometimes even futures, which introduces the need for intermediaries to keep prices efficient. As today’s data shows, hedging is one reason why shorting often occurs. Above After being added to the index: Market makers need to hedge long positions in futures, ETFs or index options, for example.
For example, when an ETF like IWM (which tracks the Russell 2000) trades below its net asset value (NAV), authorized participants buy the (cheaper) ETF and short the index components.
Over time, they may decide to cash out the long ETF for the underlying basket. Importantly, when they make ETF redemptions, the short positions will also be reduced.
hedge funds are net long
There are also other hedges that compound short positions, including:
- Variable Arbitrage: Hedge funds will remove equity exposure by buying convertible bonds and shorting the underlying stock, or exploit pricing inefficiencies.
- Option related hedges: Options market makers need to minimize the risk in their options trades by placing long or short positions in the underlying stocks and indices.
- Statistical Intermediation Activities: funds may be See Mathematical Deviation Within a sector, where the relative prices of securities against each other are unusually wide – sometimes due to their market impact on the specific stocks being purchased by investors. By buying the “cheap” stock and shorting the “rich” stock until the divergence returns to normal, they provide liquidity to both stocks.
Importantly, research shows that hedge funds are net long. In fact, their total long positions stood at $1.6 trillion (as of February 2024), with short positions totaling $1 trillion, and only 1.3% of total assets ($48.5 billion) were represented by dedicated short funds.
Short interest increases right after index inclusion
Our previous work has shown that short interest is greater in larger stocks. Larger stocks are also more likely to be included in major indices. Chart 1 illustrates this relationship by comparing short interest, market capitalization, and index inclusion.
Chart 1: Short interest is high in S&P, Russell stocks
The conclusion is clear: While small-cap stocks that are not eligible for index inclusion (gray dots on the left) have a wide spread in their short interest, 1% appears to be the “floor” of short interest for stocks included in the Russell 3000 and S&P 500.
This is a direct result of the exact reasons listed above – these mechanical factors related to index membership create a baseline level of short interest that has nothing to do with market sentiment.
Even stocks with higher market caps that are not included in the index (grey dots on the right) have less interest than stocks with similar market caps. Are included in an index.
Today, we’re taking a more closer look at what happens to companies’ short interest when they are added to the index,
As the data in Chart 2 shows, for most stocks, short interest:
- Index increase for additional stock.
- The index decreases for deletion.
Chart 2: Short interest increases in Russell 2000 additions, decline in removals
In fact, looking at the vertical axis above, we see short interest in companies added to the index, on average, more than doubling, while the average reduction in removals was about 50%. For both, the ratio is 2:1.
Showing details from the boxplot, we see that most tickers also saw these changes (50% of the universe is in the colored boxes; only 5% are outside the tips of the lines). In fact, right after the 2025 Russell restructuring:
- 99% of Russell’s additions saw short interest growth.
- 97% of removals saw a small reduction in interest.
- Whereas only 58% of the companies remaining in Russell rose.
Short interest is not always bearish
Index inclusion introduces new buyers to a company – new long-term (index) holders of your stocks and more active investors who need to pay attention to buying shares so that they are not overweighted. In turn, they increase liquidity, which should reduce trading costs.
But index inclusion also brings more professional traders interested in hedging.
Interestingly, a recent paper found that index holders are also an important part of this hedging story as they are more able to lend long-term positions to hedgers. This makes market hedging cheaper and more efficient while adding positive returns to index funds.
The data we see today clearly tells a story. When a stock is added to an index like the Russell 2000, short interest almost always increases – even if the company’s fundamentals have not changed.
This also shows one thing: higher short interest is not always bearish.
Thomas Goetz contributed to this article.
