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What Shorting ETFs Means for Long-Term Investors

What Shorting ETFs Means for Long-Term Investors

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. In August, short-sellers began betting against ARK Innovation ETF. Joining me to discuss what it means for investors when an ETF they own becomes part of a short trade is Ben Johnson. Ben is Morningstar's global director of ETF research.

Hi, Ben, thanks for being here today.

Ben Johnson: Hi, Susan. Thanks for having me.

Dziubinski: Tell us what's been going on with ARK Innovation ETF in August.

Johnson: What we saw in August was that there was a surge in the percentage of ARK's shares that were being sold short by investors. Now, that's unique to ETFs, because ETFs, like stocks but unlike mutual funds, can actually be sold short. They are traded all day every day on major stock exchanges like individual equities so investors can buy them during normal market hours. Generally, investors will go long those shares, but they can also sell those shares short if they have a bearish view on whatever the underlying exposure, the underlying strategy, the underlying market might be. Furthermore, you can even see options chains in the case of many ETFs. So, puts and calls that allow investors to generate income or otherwise hedge positions that they might take through an ETF wrapper. It's a unique feature relative to mutual funds, certainly not unique from stocks, that is specific to ETFs and I think has grown in prominence as high-profile managers, high-profile funds like ARKK attract more interest from bearish investors and most recently, and most notably, Michael Burry of The Big Short fame, who disclosed that he was taking a bearish view on ARKK, on Cathie Wood and team's portfolio.

Dziubinski: Have we seen this type of active bearishness around an ETF before?

Johnson: We've certainly seen bearish bets on ETFs. If you just look at the regular roster of some of the most shorted equity positions on major exchanges, many of the largest, most liquid ETFs feature on that list quite regularly. And they feature there regularly, because ETFs are being used by a multitude of different types of investors in a multitude of different ways, and oftentimes the short positions will just be evidence of some sort of hedging of another long position on some investor's book somewhere else within the broader ecosystem. What's particularly new and noteworthy about this is that this is a short position, a bet against a very high-profile, very prominent manager that's performed remarkably well, exists in rarefied air if you look at the long history of mutual funds and ETFs. That makes it somewhat distinct. What makes it even more distinct yet is not only are you seeing these bearish bets take the form of short interest, but more recently, there was a filing actually for a short ETF. An ETF that would allow investors to have daily short exposure to the performance of ARKK. It's not just the shorts, it's not just Michael Burry. It's also other asset managers, some of ARK's competitors that are trying to tee up ways for investors to express a bearish view on this one particular actively managed portfolio.

Dziubinski: What are the implications for long-term investors who may own an ETF that's being shorted?

Johnson: It's really going to depend ultimately on the ETF in question. Now, in the case of ARKK, what you could very well see if there is sufficient demand among short-sellers for ARKK shares to be sold short, is that that could actually somewhat counterintuitively result in inflows to the fund. Within the realm of ETFs, there's a type of activity that's called create-to-lend. And what that means is that new shares of that ETF are being created to lend to short-sellers for purposes of being able to express their bearish view. Now, that sort of activity could put more money on Cathie Wood and her team's plate to express long views with. So, what you see in that instance is a really unique feature, which could in certain circumstances exacerbate concerns around things like capacity, which we documented in detail in our March analysis of ARKK.

Dziubinski: Ben, are there any broader lessons overall from the investor behavior that we've seen around ARK Innovation ETF this year?

Johnson: I think a lot of the lessons that we might be able to learn either at the present or looking back are not by any stretch of the imagination unique to ARKK. It's a pattern of investor behavior--of, I would argue, returns-chasing behavior in particular--that we've seen in other funds recently, specifically if you look at certain cloud computing ETFs and ETFs that invest in the clean energy space. And it dates back years, decades, if not centuries, and is really just fundamental to human behavior is that we see things that are going up quite a lot and we want to participate in whatever that future upside might be. And unfortunately, oftentimes many arrive at the party too late to enjoy the lion's share of the returns that are being generated by that underlying exposure, by that manager, by that strategy.

Dziubinski: Well, Ben, thank you so much for your time today. We appreciate it.

Johnson: Thanks for having me.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.

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