A fascinating debate on the FT Alphaville site yesterday gave readers a reminder of how supposedly “simple” ETFs are linked to some of the most arcane practices in finance.
In “Can an ETF Collapse?” the anonymous Alphaville author points out that the short interest in an ETF can be many multiples of the official tally of outstanding shares.
For the SPDR S&P Retail ETF (NYSE Arca: XRT), for example, according to the author, “the number of shares short was nearly 95 million at the end of June, while the shares outstanding of the ETF were just 17 million. The ETF was over 500% net short!”
This presents a serious risk, the blog writer asserts. “The share buyer…is completely unaware his ETF shares were purchased from a short-seller and no doubt assumes the underlying assets in the index are being held by the ETF operator on his behalf, but no such underlying stock is actually held by anyone. Clearly this creates a serious counterparty risk and quite possibly the potential for a run on an ETF—where the assets held by the fund operator could become insufficient to meet redemptions.”
Not so, argue several commenters on the blog. According to Steve Waldman of the Interfluidity blog, for example, “if redemptions force shorts…to cover more shares than those who happen to be long “physical” XRT and are willing to sell, then the ETF will experience net inflows and issue new shares to meet the demand. The missing supply of ETFs would create itself. The only credit risk in this scenario is the possibility that XRT shorts turn out to be unable to cover their position.” And in practice, Waldman adds, short sellers will have posted collateral to their brokers that should cover any possible shortfall.
Here, then, is a crucial difference between ETFs and traditional stocks. Whereas the supply of the latter is fixed, at least in the short term, ETF supply is dynamic, varying as authorised participants create and redeem units of the fund in exchange for the basket of underlying index shares (or, in some cases, for cash). And it’s therefore quite understandable that ETFs can carry levels of short interest that are far higher than a stock would typically bear, since in the case of a fixed supply there would probably be an immediate squeeze on short sellers, pushing up the share price.
There may be other concerns arising from the very high levels of ETF shorting, though. Waldman argues that retail owners of margin accounts may be unaware that the ETFs they own may be being lent out by their broker (this is one of the routes whereby short sellers obtain their supply), presenting a possible counterparty risk to the brokerage firm and a risk of losing money if the latter collapses.
More broadly, I presume, however the creation/redemption mechanism may function in practice to permit the operation of significant short ratios in individual ETFs, the higher the gross long and short positions in relation to the official ETF share total, the greater the potential for price disturbance if something were to interfere with the smooth running of that same process of creating and redeeming ETF units.
Paradoxically, blanket restrictions on short selling of the type we saw in 2008 (which are now being mooted at a Europe-wide level) might be just such a trigger for disruption, potentially causing exactly the problems in financial markets that they are supposed to alleviate.
And, of course, the security of custodial arrangements is key from an investor’s perspective. The Lehman failure and the losses that resulted from the practice of rehypothecating investor cash are a reminder that this is still a complex and little understood area of market practice.
On that note, I’m heading to next week’s ISJ European Custody Summit in an attempt to find out more about the securities custody, lending and prime brokerage business, which is clearly critical in understanding how ETFs really work.
And if the example of XRT is not, in my view, the sensationalist picture of shorts running amok that many paint it to be, it’s at least a reminder of how ETFs are pushing the boundaries of a whole range of relationships between financial institutions.
