There are advantages to be had, but few advisors jump in.
Financial advisors who use exchange-traded funds
(ETFs) are an evangelical lot. They'll rattle on about the tax
efficiency, low fees and absolute transparency of their favored
products; they'll discuss the joys of real-time trading; they'll even
remind you that ETFs are immune from market-timing scandals.
But one of the most interesting advantages that ETFs have over traditional mutual funds is one you rarely hear about: The fact that they can be sold short. I read interviews with and research papers by financial advisors every day, and they never discuss shorting ETFs. A Google search for "shorting ETFs" and "financial advisors" turns up next to nothing.
And yet, selling ETFs short is big business: According to Morgan Stanley, 17% of all the shares outstanding for U.S.-listed ETFs were sold short as of June 2005. In contrast, short interest on individual stocks rarely rises above the single digits, and most experts put the blended market average close to 2% or 3%.
This discrepancy can be explained in short interest in a minute, but first, let's ask the question that spurred this article: Are financial advisors just being coy, shorting ETFs but not talking about it publicly? Or are they missing out on what is obviously a valuable product for a large number of investors?
To find out, I contacted more than 20 financial advisors who use ETFs in client portfolios. Of those, only two have ever used ETFs on the short side. Hoping to find more examples, I contacted the public relations departments of the two largest ETF providers in the world: Barclays Global Investors and State Street Global Advisors. PR departments are always eager to put journalists in touch with advisors who use their products-it's like free advertising for them-so I figured they could help.
No luck; both PR departments came up empty.
The advisors I spoke with offered a variety of explanations for why they don't use ETFs on the short side, with most saying that they simply prefer to hedge their clients' portfolios using traditional asset allocation strategies. Even those advisors who do short ETFs say that it can be difficult to explain the value of a short position to a client, particularly when the overall market is rising.
But advisors who dismiss the "shortability" of ETFs outright miss a real possibility to protect their portfolios against a fall in a particular sector, style or country-and soon, against a rise in the price of oil or the value of the Euro. And at a time when some experts believe that the traditional non-correlated asset classes-such as gold and oil-are trading at speculative levels, the shortability of ETFs could prove more useful than ever.
Short-sellers get a bad wrap. The media and the financial establishment casts them as evil-minded scoundrels who snoop around in dark corners looking for dirty laundry, searching for the next big scandal. CEOs of heavily shorted companies rail against their existence. You can talk all you want about how short-sellers improve the efficiency of the market, but in the end, most people don't like them; they are the vultures who profit from everybody else's pain. It's not exactly the trustworthy image most advisors try to present.
That's part of the reason why most financial advisors favor traditional (long-only) asset allocation strategies, using (historically) non-correlated assets to ensure that some part of a client's portfolio is always doing well, even if most of the portfolio is in a funk.
"We don't use ETFs on the short side in our separate accounts," says David Elan, a principal at Windward Investments, which manages $450 million in client assets using traditional asset allocation strategies. "But because many of the positions we hold exhibit low or negative correlations to other asset classes, they essentially function like shorts."
Elan argues that gold, commodities and longer-dated U.S. Treasuries are all real "safe havens" from the U.S. equity markets.
Short-selling, in contrast, is seen as risky. After all, you can lose an infinite amount of money in a short position, because a stock or ETF can theoretically go up forever. More importantly, it can go up quickly, especially in a "short squeeze." A short squeeze occurs when a heavily shorted stock gets a bit of good news, sending the share price up. As the price rises, short-sellers begin to panic, and they rush to close out their positions by buying back the stock. That pattern builds on itself, forcing the stock higher and higher. If a stock is thinly traded, the movement can be violent. You often hear about traders getting caught on the wrong side of a short squeeze.
But one poorly understood fact is that short squeezes don't happen with ETFs. Short squeezes depend on limited liquidity-a bunch of short-sellers chasing a thinly traded stock. Because ETFs are really just baskets of publicly traded stocks, ETF providers can create new shares of an ETF at any time. The fact that ETFs can't be "squeezed" is one of the reasons why short interest is so much higher for ETFs than for most common stocks.
"As a practical matter, the idea of cornering an ETF market is unimaginable," writes Gary Gastineau, one of the key players in the early success of ETFs and a principal at ETF Consultants. "Short-selling in ETF shares is a low-risk activity, because short squeezes are not possible and most short sales are made to reduce an investor's portfolio risk."
Gastineau's second point is an important one. Whereas short-sellers are viewed as big risk-takers by the media, the reality is that shorting ETFs can play a key role in reducing risk for client portfolios-a fact that many advisors are beginning to discover.
"One thing I build into every account is a hedge," says Roger Nusbaum, an investment advisor with Your Source Financial in Phoenix, who helps manage more than $45 million in client assets. "You never know when something bad will happen in the world that will impact the market-a terrorist attack, etc. And if things really do get nasty in the market, that's when the short position will do the heavy lifting."
Nusbaum says that some of his clients prefer long exposure to noncorrelated assets, such as gold. But for at least two-thirds of his clients, he creates some kind of short exposure to a major index, often by shorting the Standard and Poor's Depositary Receipt (SPY), the world's largest ETF, which tracks the S&P 500 Index.
There are other ways, of course, to shield a portfolio on the downside-say, by writing puts against one of the major indexes. But Nusbaum believes this is even more difficult to justify to the client. "The short is really there as an insurance policy that doesn't go to zero. That's why I don't use put options; put options go to zero," he says. "It's easier to explain the value of the short position - sometimes it's up, sometimes it's down-than to throw a few basis points to put positions that are constantly going to zero."
Still, even short devotees like Nusbaum say that explaining the value of the short position to clients can be a challenge. "It can be very difficult to explain to a client-in a situation where things are going well and the market is up-why they're holding this one short position that is down, say, 21%," Nusbaum admits. "It's really does take training of the client."
Beyond risk management, a few financial advisors are starting to leverage the shortability of ETFs to generate alpha for their investors.
J.D. Steinhilber, founder of Agile Investments in Nashville, Tenn., an ETF-focused advisory group, primarily uses ETFs in the traditional manner: pursuing diversified asset allocation strategies. But for more aggressive clients, he's beginning to use ETFs on the short side, both for hedging purposes and to generate alpha.
"I don't do it often. But I have certain clients who are interested in that level of active management," says Steinhilber. "Where it comes into play most often is in hedging existing positions or putting on a spread against asset classes-when one asset class is more attractive than another."
The idea of creating a long/short spread on different asset classes takes Steinhilber beyond the traditions of risk management and into the field of active, almost hedge fund-like activity. Steinhilber is quick to point out the potential pitfall of these spreads, and to emphasize that it's not the right strategy for most clients. "After all," he says, "you can be wrong on both sides of the equation."
But according to some industry experts, Steinhilber may be on the right track, and more advisors might have to follow his lead in the years to come. David Fry has been involved in the investment management business for more than 30 years, and now publishes ETF Digest, an ETF trading advisory service with a strong track record in the markets. According to Fry, it's becoming easier for individual investors to execute their own basic asset allocation strategies using products like ETFs, and that means that financial advisors will have to work harder to justify their fees. "For financial advisors, the big story today is that to compete, justify high fees and retain clients who may become do-it-yourself investors, they'll need to operate like a hedge fund manager," says Fry. "To do this, they'll need shorting capabilities."
Other Risk Management Approaches
While few advisors are ready to jump into long/short pairs trades, an increasing number are exploring new ways to use ETFs for risk management. At Main Management in San Francisco, for instance, they are developing a new product which overlays the traditional "buy-write" options strategy on a carefully balanced portfolio of ETF positions.
In the buy-write strategy, an investor buys a long position in an equity or ETF, and then sells (or "writes") call options against that position. By selling the call, the investor is shielded from a fall in the value of the equity position-although they lose out on any upside, too. The way the strategy makes money is by generating income from the sale of the call options, and by gathering up the dividends paid out on the equity position.
The strategy has been made famous by the Chicago Board Option's Exchange's S&P 500 BuyWrite Index, which applies a simple buy-write strategy against long positions in the S&P 500. That strategy has outperformed the index itself over the past decade, with less risk. Not surprisingly, it has spawned a number of closed-end funds, which have pulled in billions of dollars over the past year.
Main Management follows a similar approach, but it uses a diversified portfolio of ETFs and ETF options, rather than the large-cap only focus of the S&P 500. That way, the entire strategy enjoys the benefits of a traditional asset allocation program, with the added risk reduction of the buy-write strategy.
"We anticipate a high-single-digit type of return for that strategy, with a lot lower volatility than in a straight equity portfolio," says Kim Arthur, who helps Main manage $150 million in client assets. "On the upside we capture about 85% of the market return, and on the downside we get about a 35% protection."
Arthur says that the strategy is particularly attractive when applied to high-yield ETFs, such as the iShares Dow Jones Select Dividend Fund (DVY). He does admit, however, that high turnover makes the strategy more appropriate for nontaxable accounts. Still, at a time when many are calling for a few years of sideways markets, the ability to reliably capture a high single-digit return could be attractive.
New Products, New Opportunities
As ETF providers roll out ever more innovative products in the years to come, the number of interesting short opportunities will only increase. Already, advisors can use ETFs to short almost any style, sector or regional slice of the market. They can also use ETFs to short bonds, as a hedge against rising interest rates; this was a hugely popular strategy earlier this year, when more than 20 million shares (representing $2 billion) of the iShares Lehman 20+ Year Treasury Bond Fund (TLT) were sold short (see Figure 1). Soon, ETF providers will be rolling out products granting direct access to the Euro currency and to the price of oil. It's easy to see how these positions could fit into a portfolio on the short side, in the right situation.
Although many advisors are reluctant to short ETFs, it's important to remember that ETFs are less risky on the short side than individual stocks, as they are not susceptible to short squeezes. In fact, it's often easier to short ETFs than it is to short individual stocks, as most ETFs are exempt from the so-called "uptick rule," or Rule 10a-1 of the Securities and Exchange Commission Act of 1934, which prevents investors from selling shares short if a stock is falling. The rule is designed to prevent short-sellers from exacerbating downward moves in stocks. As far as the SEC is concerned, you can sell most ETFs wherever, whenever.
Things aren't perfect. There are widespread reports that some ETFs are difficult to short at different times, particularly for individual investors. But most of the time, the system functions well.
Using ETFs on the short-side isn't for everyone, and it's certainly not appropriate for every client. But it always pays to have more tools at your disposal rather than fewer, and the shortability of ETFs is just such a tool.
Matthew Hougan is assistant editor of
the Journal of Indexes and a contributing writer for IndexUniverse.com
and the Exchange-Traded Fund Report.