Equity Mispricing: It's Mostly on the Short Side

In the large-cap sector of the U.S. equity market, the degree of mispricing is much greater for stocks one would like to sell short than for stocks one would like to buy long. For example, if no attempt is made to control tracking error, large-cap short/sell candidates tend to be overpriced by as much as four times the amount the large-cap long/purchase candidates are underpriced. With respect to tracking error, we found that controlling for firm size, even in the large-cap sample of stocks we examined, significantly reduces tracking error. Controlling for value versus growth also reduces tracking error. Once one controls for value versus growth and firm size, controlling for economic sector has relatively little effect on tracking error. We investigated mispricing in the large-cap sector of the U.S. equity market. To explore stocks that appear to be overpriced (short/sell candidates) and stocks that appear to be underpriced (long/purchase candidates), we examined one anomaly from among many in the literature classified as value strategies and one anomaly from among many in the literature that might be classified as growth strategies. The value criterion was a combination of low p/E and share repurchase; the growth criterion was earnings surprise.Our principal finding is that among the S&p 500 Index stocks, the short/sell candidates identified by either strategy (value or growth) tend to be much more overpriced than the long/purchase candidates are underpriced. For example, in the case where we did not control for risk, the alpha for the short/sell candidates using the value criterion was −7.9 percent compared with +1.3 percent for the long/purchase candidates. When we used the growth criterion (and no risk control), the alpha for short/sale candidates was −9.7 percent compared with +3.8 percent for the long/purchase candidates.In our tests, we also controlled for three dimensions of risk relative to the S&p 500: style (in this case, value versus growth),size (market capitalization), andindustry exposure.We looked at these measures with respect to controlling tracking error. Combining both the value strategy (long and short) with the growth strategy (long and short) reduced tracking error substantially. In addition, controlling for firm size (even within the S&P 500 stocks) considerably reduced tracking error. After controlling for value versus growth and for firm size, controlling for economic sector weights did not reduce tracking error significantly.Given the significantly larger mispricing for short/sell candidates, the following strategy might be desirable for U.S. plan sponsors who want an enhanced index portfolio: Using both value and growth strategies, construct a dollar-neutral long–short portfolio, with most of the emphasis placed on identifying mispriced short candidates, and equitize the portfolio by buying S&P 500 futures contracts.