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By Paul Justice, CFA | 09-24-2010 03:49 PM

ETF Collapse Concerns Unfounded

Short interest does not pose a problem for standard ETF shareholders, says Morningstar's Bradley Kay.

Paul Justice: Hi, I'm Paul Justice, director of North American ETF research at Morningstar. Today I'm joined by Bradley Kay, the director of our European ETF research team, and we are here to talk about all the things that come with the onset of autumn--including predictions of disaster in financial markets following the financial crisis of 2008, and now new stories talking about how ETFs may equally lead to a collapse either in the market or to funds themselves.

Bradley, I am talking about a particular article that came out earlier this week that referenced some peculiarities, especially in the short interest of ETF. Are people selling short shares, that's called "Can Your ETF Collapse?"

Bradley Kay: Yes, I know. There have been some instances. We've seen actually in the past even in say 2008 it occurred. But now, there's a particularly eye-popping example in the XRT, the SPDR Retail fund, I believe, where you have a short interest. In other words people have put short positions in this fund that are five times the size of the actual assets that are there in the funds. And unless you have a bit of an understanding of how the share-lending market works, how the shorting market works, this can look pretty bad at first. Unfortunately this article really did leap to conclusions without taking that deeper understanding.

Justice: No, I could see initial cause for a concern, if there is 500% short interest and I am an owner of that ETF. I am thinking to myself, what, do I not actually own this ETF right now? Do I not have stock backing up my shares? That's something I should be concerned about?

Kay: Exactly, is there a chance that you bought shares off the exchange and they happen to be, say, phantom shares produced by a short seller. But in reality thankfully that isn't the case. What tends to happen, if you are trying to short shares, you have to borrow them first, and so that is really the key to this entire issue.

If you go and sell shares without having borrowed them first, three days later you are up the creek, because you do not actually have any shares that you can deliver--three days being the settlement period for equities and ETFs.

What you instead do is you go into the institutional borrowing market. You find an institution who is already holding those shares or is willing to buy those shares and hold them for you, and then that gets lent to you who want to short the shares. In turn you provide collateral that is worth just as much as the shares you're borrowing.

Justice: Sure. So, two keys here; one, there is an exchange of goods. There is collateral exchanged for shares in order to conduct the borrowing for the full value of whatever that ETF maybe worth; and also there's compensation paid to the person who is lending it out.

Kay: Exactly, and the key is that the person who's lending out the shares, frequently a major institution, knows that those shares are lent out. And in fact, once those shares are lent out, they are no longer eligible to be redeemed. That's actually in many of the ETF prospectuses. That is something that any authorized participant and the provider would be checking for, if you try and submit shares for redemption. And we also know that those shares cannot be sold because there is this lending out there right now. If they wish to sell those shares, they can either go to the person borrowing them and doing the short sell, and they can demand those shares back, or they can take some of the collateral, create new shares to replace those lent shares.

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