Like many innovations in finance that emerge from nowhere to explode in
popularity with unknown consequences, exchange-traded funds (ETFs) have gone
from obscurity when they were first invented in 1993 to making up more than
half of all the daily trading volume on American stock exchanges today.
They also made up 70% of all the canceled trades during the Flash Crash
on May 6, despite representing just 11% of listed securities in the United
States, suggesting that ETFs remain poorly understood by both investors and
regulators.
The extraordinary popularity of exchange-traded funds, open-ended mutual funds
that trade like stocks on an exchange, is undeniable. However, the source of
this popularity would seem to have two very different origins. ETFs are
bought by many retail and institutional investors looking for low cost and
highly liquid vehicles with which to buy whole indices in a single trade, and
ETFs serve that noble function well. But, they are also extremely popular
with and widely used by hedge funds and other traders looking for a simple way
to mitigate broad-market risks, or neutralize beta, with a single trade.
The appeal to a hedge fund manager of being able to short an entire
market index or a whole sector with one transaction, instead of say 500
separate stock shorts to span the S&P 500 Index, makes ETFs very widely
used as hedging vehicles by short-sellers. It increasingly looks like
many new ETFs are now being designed for the purpose of marketing them to
short-sellers.
These seemingly opposite interests in ETFs make for a large and lucrative
market not just for the ETF operators like BlackRock’s iShares and State Street
Global Advisors SPDRs, but also for the authorized participants--institutions
that can create or redeem large blocks of new shares in an ETF (called creation
units) for sale, and countless brokers that profit by trading ETF shares.
While ETFs often appear to be a benign innovation as compared to some of Wall
Street’s arcane derivatives, a closer look at the mechanics of short selling
ETFs (which have become one of the most prevalent securities to short) raises
some serious concerns. While an ETF owner believes their ETF shares
represent ownership of the underlying shares of stock in the index that the ETF
tracks, that stock is not always all there. Because of explosive short
interest in some ETFs, owners of ETF shares often far outnumber the actual
ownership of the underlying index equities by the ETF operator. One might
ask how that can be possible, but the creation and redemption mechanisms
inherent to ETFs mean that short sellers need not be concerned about the
availability of shares outstanding when they sell an ETF short—since they can
always create new shares using creation units to cover short positions in ETFs
in the future. In essence, there appears to be little risk to being short
an ETF since the short seller can always “create to cover”. This has led
to some ETFs having shockingly large short interest as compared to their number
of shares outstanding and for every additional ETF share sold short, there is
another owner of that share.
Take the SPDR S&P Retail ETF (NYSE: XRT) as an example. 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! Or to look at it from another perspective, the ETF’s operator,
State Street Global Advisors, believed that there were 17 million shares of the
SPDR S&P Retail ETF in existence and owned shares
in the S&P Retail Index portfolio to underlie those 17 million ETF shares.
But, in the marketplace there were another 95 million shares of
the ETF owned by investors who had purchased them (unknowingly) from
short sellers. 78 million of those ETF shares were serial short—that is they had been borrowed and re-sold more than
once--or they were naked short (not borrowed at all). The short sellers had promised their
prime brokers to create those non-existent shares (above and beyond 100% of the
shares outstanding) if necessary to cover their short in the
future. In both cases the share buyer, however, 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.
Even more alarming was the recent rate of redemptions from the SPDR S&P
Retail ETF in July and August 2010. Redemptions occur when more owners
wish to sell out of their holding in the ETF than there are new buyers for the
existing shares, so unwanted blocks of 50,000 ETF shares each are
redeemed through the authorized participants with the ETF operator for
cash, or more typically for in-kind shares in the ETF’s underlying index’s
stocks. The SDPR S&P Retail ETF was one of the fastest contracting
ETFs in July due to redemptions and as of July 31, it had just 7 million shares
outstanding. However, the short interest was little changed—still over 80
million shares short. Suddenly, 11 times the number of shares outstanding
was short, which is even more worrisome than 5 times back in June. By late
August, the shares outstanding in XRT had dipped briefly below 5 million shares
with 80 million shares still short (16 times the shares outstanding).
Mercifully, net buying interest has rebounded somewhat for the SDPR
S&P Retail ETF with the improving outlook for retailers and shares
outstanding in XRT had rebounded to 12 million by mid-September. But if
the rate of contraction last month had continued, the ETF was just days away
from running out of underlying stock altogether.
So what happens if the recent
monthly redemption rates return and 15 million more
shares in the ETF were redeemed by the end of this month? Presumably the
SPDR S&P Retail ETF might simply close and cease to exist once its
remaining 12 million ETF shares outstanding had been redeemed and all its
underlying equity holdings had been delivered to redeeming authorized
participants. But where does that leave all the ETF owners who
unknowingly bought their shares in the ETF from short sellers? If the ETF
is all out of underlying equities and is essentially shut down, what happens to
the remaining owners of the 80 million shares of the ETF? The ETF
operator would have no more underlying shares (or cash) in the fund and the ETF
would have essentially collapsed since all the shares outstanding were already
redeemed. At recent prices the unfunded remaining ownership in the
marketplace for which nobody currently owns any shares would be over $3 billion
for just this one ETF! Extend this hidden unfunded liability from massive
scale short-selling of ETFs (both traditional and serial) across the entire ETF
spectrum and it is a $100 billion potential problem.
Who gets left holding
the bag? Is it the retail account holders who own defunct shares in a
closed ETF? The prime brokers that were counterparties to all those short
sellers? The hedge funds that sold non-existent shares in an ETF assuming
they could always be created another day? The ETF operator? Or the
Federal Reserve?
