Stock short-selling is a widely known practice, but short-selling of exchange-traded funds is becoming more popular among institutional investors for a variety of reasons.
The practice was unheard of five or 10 years ago. But George Trapp, head of securities lending client relations at Northern Trust, says there is about $37 billion on loan for ETFs in the securities lending marketplace. Although that represents a little less than 2 percent of total on-loan volume for securities lending, Trapp says it shows there’s a growing demand for ETFs used in short sales.
There are a variety of reasons that an investor might want to short-sell an ETF rather than outright short-sell the underlying security, say people in the industry.
Ben Johnson, director of global ETF research at Morningstar, says an investor might want to hedge a position, or it could be a pair trade.
Matt Collins, head of U.S. product at ETF Securities, says it can also be a directional bet on a sector or an individual name, and by selling the ETF there’s less direct impact on the stock and the investor can do so quietly.
“If you were to short-sell a million shares in an ETF, you’re not going to have much impact on the underlying securities,” Collins says. “When you short-sell a million [shares in] stocks, you would give away your position. By short-selling the individual security, you also might push [the price] down so much, you’ve already pushed it down to where you thought it would be.”
The benefits to the ETF lender is to generate incremental income, Trapp says. The ETF owner can sometimes earn one-half to one percent on an annualized basis on top of whatever return they make on the ETF itself, essentially covering the ETF’s fee.
Should investors holding an ETF and not participating in lending or short-selling be worried about how it affects them? Not necessarily, the sources say.
The actual short-selling of ETFs and individual securities are similar—i.e., borrowing an ETF or a stock. But the market impact is different. Unlike stocks which have finite supply, ETFs can be created and destroyed as needed without affecting how the ETF tracks the index.
“This wouldn’t have any effect on the ETF’s underlying net asset value nor its price, which is going to be regularly struck between buyers and sellers so there wouldn’t be any impact in that respect,” Johnson says.
Why should financial advisors care about this if ETF short selling doesn’t affect a product’s price or its NAV? The reason, Collins says, is these moves can be positions on how short-sellers view the overall outlook for the underlying securities, which may be bleak.
Any ETF can be a candidate for short-selling, but Trapp and Collins say many sellers usually look for highly concentrated ETFs in a subsector. Market direction may be another reason, Trapp adds.
“The demand is for specific ETFs [that are] more volatile, where you might see more pricing pressure, like retail ETFs or some of the high-yield bond ETFs, Trapp says. “That’s typically where we see the largest demands.”
He adds that he’s seeing more demand to borrow fixed-income ETFs to hedge or to anticipate rate hikes.
Short-selling ETFs can add to the market’s liquidity, which is often cited as a trademark benefit of ETFs, Johnson says.
“[Since] these funds trade like stocks, they have a degree of flexibility that is stock-like,” he says. “Not just in their liquidity feature that they trade during normal market hours, but that they can be sold short.”
Financial advisors should know that the number of funds created to sell short can be significant, sometimes up to 50 percent of the fund or more, Collins says. That makes simply looking at total outstanding shares for any given fund not always a bullish sign.