The Short Story on Index Inclusion

We’ve talked in the past about how the mechanics of short selling work, and how the rules around trading, holding, and reporting do, too. However, there remain a lot of misconceptions out there 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 passive 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 addition to an index is good for companies; it means index funds will buy and hold your stock longer term and active funds need to decide if they want to stay underweight your stock. 

It also results in inclusion in exchange-traded funds (ETFs) and, sometimes, futures, which introduces the need for arbitrageurs to keep prices efficient. As today’s data shows, hedging is one reason why shorting often goes up after being added to an index: Market makers need to hedge, for instance, long positions in futures, ETFs or index options.

For example, when an ETF like IWM (which tracks the Russell 2000) trades below its net asset value (NAV), authorized participants buy the (cheap) ETF and short the index constituents. 

Over time, they may decide to redeem the long ETF for the underlying basket. Importantly, when they do that ETF redemption, the short position would also be reduced.

Hedge funds are net long

There are other hedges that also add to short positions, including:

• Convertible arbitrage: Hedge funds will hedge away equity exposure, or exploit pricing inefficiencies, by buying convertible bonds and shorting the underlying stock.
• Options related Hedges: Options market makers need to hedge exposure to their options trades by having long or short positions in underlying stocks and indexes.
• Statistical Arbitrage activities: Funds may see mathematical deviations within a sector, where the relative values of securities against each other are unusually wide – sometimes caused by natural investors’ market impact on a specific stock they are buying. By buying the “cheaper” stock and shorting the “richer” stock(s) until the deviation returns to normal, they provide liquidity into both stock(s).

Importantly, research shows that hedge funds are net long. In fact, they had a net long position of $1.6 trillion (as of February 2024), with $1 trillion short in total, and only 1.3% ($48.5 billion) of total assets represented by dedicated short funds.

Short interest rises right after index inclusion

Our past work has shown that larger stocks tend to have higher short interest. Larger stocks are also more likely to be included in major indexes. Chart 1 shows this relationship by comparing short interest, market capitalization, and index inclusion. 

Chart 1: Short interest is higher in S&P, Russell stocks

The takeaway is clear: While smaller-cap stocks that don’t qualify for index inclusion (grey dots on the left) have a wider spread in their short interest, there appears to be a “floor” of 1% 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 aren’t included in an index (the grey dots to the right) have lower short interest than those with a similar market cap that are included in an index.

Today, we are looking more closely at what happens to companies’ short interest when they are added to the index.

As the data in Chart 2 shows, for the majority of stocks, short interest: 

• Increases for index addition stocks.
• Decreases for index deletions.

Chart 2: Short interest rises in Russell 2000 additions, falls in removals

In fact, looking at the vertical axis above, we see short interest in the companies added to the index, on average, more than doubled, while the average decrease in removals was around 50%. For both, a ratio of 2:1.

By showing the details from the boxplot, we see that the majority of 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 reconstitution:

• 99% of the Russell additions saw a short interest increase.
• 97% of the removals experienced a short interest decrease.
• While only 58% of the companies that remained in the Russell had an increase.

Short interest isn’t always bearish

Index inclusion introduces new buyers to a company – new long-term (index) holders of your stock and more active investors who need to look at buying shares so that they are not underweight. They, in turn, add to liquidity, which should reduce the costs of trading.

But index inclusion also comes with more professional traders interested in hedging.

Interestingly, a recent paper found that index holders are also a key piece of this hedging story as they are more able to lend long-term positions to hedgers. That makes hedging the market cheaper and more efficient, while adding positive returns to the index fund.

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 rises — even though the fundamentals of the company haven’t changed.

One thing this also shows: Higher short interest isn’t always bearish. 

Thomas Goetz contributed to this article.