Small hairpin RNAs (shRNAs) having duplex lengths of 25-29 bp are normally processed by Dicer into short interfering RNAs (siRNAs) before incorporation into the RNA-induced silencing complex (RISC). However, shRNAs of ≤ 19 bp [short shRNAs (sshRNAs)] are too short for Dicer to excise their loops, raising questions about their mechanism of action. sshRNAs are designated as L-type or R-type according to whether the loop is positioned 3' or 5' to the guide sequence, respectively. Using nucleotide modifications that inhibit RNA cleavage, we show that R- but not L-sshRNAs require loop cleavage for optimum activity. Passenger-arm slicing was found to be important for optimal functioning of L-sshRNAs but much less important for R-sshRNAs that have a cleavable loop. R-sshRNAs could be immunoprecipitated by antibodies to Argonaute-1 (Ago1); complexes with Ago1 contained both intact and loop-cleaved sshRNAs. In contrast, L-sshRNAs were immunoprecipitated with either Ago1 or Ago2 and were predominantly sliced in the passenger arm of the hairpin. However, 'pre-sliced' L-sshRNAs were inactive. We conclude that active L-sshRNAs depend on slicing of the passenger arm to facilitate opening of the duplex, whereas R-sshRNAs primarily act via loop cleavage to generate a 5'-phosphate at the 5'-end of the guide strand.