Thursday, October 7, 2010


Like many innovations in finance that emerge from nowhere to explode in popularity with unknown consequences, exchange-traded funds 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 no risk to being naked 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 - 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 naked short–the short seller had promised their prime broker to create those non-existent shares 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 shares 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 would 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 naked 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 naked) 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?

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