ETF Collapse Concerns Unfounded

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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Justice: Okay. So the creation-redemption process once again can save the day in case there's major changes in the activity of the market if short interest drops dramatically or something like that, if there is basically a short squeeze?

Kay: Exactly. So with an issue such as this with XRT, what you're running into is there is a lot of interest in selling it short, partially because it's a fairly small sector. It's a lot of smaller-cap retail that doesn't have great prospects right now.

Justice: Sure.

Kay: Well that means that short sellers are going to be out there and trying to sell it short and when they go out there, they are essentially finding an institutions willing to lend them the shares. Quite often that means an institution isn't even holding the shares themselves. They don't really want to hold something that everything else is trying to short.

Justice: So these people tend to be pretty savvy?

Kay: Exactly. So they will go out there, buy all the underlying shares, create the ETF, and they will hedge themselves on the other side. So they even have a short position meaning that they have no market exposure.

Justice: Sure.

Kay: They will lend those ETF shares and they will demand a pretty high rate back on the borrowing because of course…

Justice: ...They are getting compensated for their trouble.

Kay: Exactly.

Justice: ...Going through all this and take the hedge position.

Kay: Going through all this. The hedge fund can then sell off those shares. Now the problem is that there may not really be anyone on the market, who wants those shares either, because everyone else can see the writing on the wall. So quite often what happens when that hedge funds goes out and sells the shares is that you now have, say, maybe a few people on the market who will take that position.

Let's say there's a $100 million worth of shorting that goes on. So the institution that did the creation-lend has $100 million long of the ETF. They have $100 million short position to keep the market neutral. That's their own hedge, and they have $100 million of collateral from the hedge fund. The hedge fund now has submitted that $100 million; they've sold that $100 million worth of shares onto the market via the exchange, you may actually see only say $20 million of that actually being picked up by shareholders who say, "Hey, this is a good idea. I want to invest in it."

Now bear in mind out of that original $100 million that got created, that did actually all go into the trust. That all flew through into the trust. What you'll then see is say maybe another $80 million of that there is no one on the market who wants to buy it. So instead it actually ends up getting picked up once again by these market makers, these arbitragers who just redeem it straight away.

And so that means that only $20 million that got sold through to the market and actually picked up by long-term shareholders ends up in the trust. And that means that everyone who is actually holding on to this out there in the market and may want to redeem their shares, can't, because there is that $20 million that's left in there. But now you have $100 million of added short interest and $20 million of added actual long-term assets. And that's because everyone else went and redeemed when they saw this investment looking very poor.

And that's how in these cases you can end up with a huge short interest relative to the size of the assets. That's because there is this tiny pool of long-only investors who are looking at it as an actual investment and everyone else is hedging it, providing collateral, they are accounting for the full value of it, and so you see very little net economic danger. But it's mostly just because it's all unseen. It's in the hidden plumbing of the financial system that this is all occurring.

Justice: Sure. And we don't witness any of the streaking by the naked shorts here. We've got collateralized positions.

Kay: Exactly. Naked shorting is far more dangerous than streaking I'd say in most cases.

Justice: Well, it's an interesting discussion, but I think it just highlights some of the issues that there is a lot more interest in poking holes in ETFs these days, it's really, kind of, just comes back to show how relevant they've become in the global marketplace.

So I am sure we are going to have many more discussions similar to this, like, is there any gold in the vault of SPDR Gold. Yes there is, but interesting dialog. I appreciate you provided your insights today.

Kay: Thank you very much.