Articles

Coming Up Short?
By Matt Hougan

Related ETFs: TLT / EWZ / EFA / EEM / IWM / SMH / DIA / SPY / DON / SMH

In March of this year, with the Federal Reserve poised t o raise interest rates for the first time in years, investors began to bet big against bonds using ETFs. How big? According to prominent ETF consultant Gary Gastineau, short interest in the popular iShares Lehman 20-Plus Treasury Bond Fund (TLT) surged to an astounding 697% of total shares outstanding.

In one sense, it was a triumph. The very fact that short interest could surge so high without disrupting trading points to the unique flexibility that ETFs offer.

But for Dave Fry, editor of the newsletter ETF Digest, that triumph was hollow. When Fry recommended to his subscribers that they short TLT, the response was unanimous.

"Schwab, Brown & Co., Fidelity, Scottrade, T.D. Waterhouse: it didn't matter," said Fry. "My readers - retail investors - were unable to find shares to short."

As his subscribers probed, they found that the problem extended to other ETFs, including most of the country-specific funds. Fry couldn't believe it.

"Retail investors go to the websites promoting ETFs and shorting is one of the features they read about," Fry said. "But when the time comes to short 100 or 1000 shares, they can't do it."

In Fry's opinion, it's misleading for the industry to tout the shortablitity of ETFs when, in reality, that benefit is hard to deliver.

Some of the ETFs that are the most appealing short targets (like individual country ETFs and, at the moment, fixed-income ETFs) are among the most difficult to short. Although the situation varies from day to day and from brokerage to brokerage, traders, specialists and ETF advisors suggest that the following ETFs can be easy or hard to short:

EASY TO SHORT	HARD TO SHORT
SPY - S&P Depository Receipts	TLT - iShares Lehman 20+ Year Treasury Bond
DIA - Diamonds Trust	EFA - iShares MSCI EAFE Index
QQQ - Nasdaq 100 Trust	EWZ - iShares MSCI Brazil
IWM - iShares Russell 2000	EEM - iShares Emerging Markets
SMH - Semiconductor Holdrs	IYV - iShares Dow Jones US Internet Index

EASY TO SHORT	HARD TO SHORT
Large Share Quantities	Small Share Quantities
ETFs with corresponding futures	ETFS without futures
Domestic	Foreign
Large Float	Small Float
Established	Recently Introduced

Hard To Short Or Hard To Borrow?

One man who has heard from Fry on the issue is Kevin Ireland, vice president in charge of ETFs at the American Stock Exchange.

"It's not that ETFs are hard to short," Ireland says when asked about the issue. "It's that sometimes they are hard to borrow."

As Ireland explained, the rules governing short sales for ETFs are very liberal: shares can be shorted at any time, and are generally exempt from the uptick rule. Moreover, unlike most stocks, ETFs are open-ended: If short demand outstrips supply, specialists can simply create new shares of the ETF to loan out. In theory, the short supply is unlimited.

Where the promise of shortability breaks down, then, is not in the product itself, but in the execution of the trade.

To sell shares short, a broker must first borrow those shares from another investor; after all, you can't sell what you don't have. To do this, he'll call his stock loan department and ask them to locate an investor willing to loan the shares. With most stocks, the loan department has two choices: They can either borrow the shares from another account at their firm (in-house), or they can call around to other institutions looking for shares to borrow. With ETFs, they have a third choice: They or another institution can create a new basket of ETF shares, and then loan out some of those shares to fulfill the order while hedging against the shares they don't loan to neutralize any market risk.

Needless to say, those three steps take three different levels of effort.

"With some of the online brokerage firms, if they don't have ETF shares available for lending in-house, they're not going to go out of their way to fill a small lending order," said Jim Ross of State Street Global Advisors. "It's just may not be worth the commission."

Even Fry acknowledged this.

"It used to be that your broker would work an order all day," Fry said."But with the discount brokers, it's strictly fill-or-kill."

Ireland notes that as more brokerages have built up in-house positions in ETFs, calls and complaints have dropped significantly. Still, he admits that he continues to receive complaints, in part because investors know that - in theory - the specialists can always create new shares.

"We'll get calls from people looking to short 200 shares of an ETF, and if they can't find it, they'll ask why someone doesn't just create more," said Ireland ." We'll, it's not that simple."

To illustrate his point, Ireland brought up the example of the iShares MSCI EAFE Index fund (EFA).

"EFA encompasses fifteen countries and forty-seven different currencies and all different kinds of settlement issues," said Ireland . "With 100,000 share baskets, creating shares of EFA to loan out involves a $10 million package that's very, very complicated to assemble, let alone to hedge. And if it costs more money to carry the position than you can get loaning it out… Well, it's just economics."

Still, at least one specialist said that his firm was always willing to create shares for the ETFs they cover, if only the stock loan desks would call around and ask.

"We never hold back," said the executive, who asked not to be named. "If we did, people would dismiss the product.And that's the last thing we want."

Ireland said that he forwards complaints about short selling to specialists, and that most of the time, the specialists are able to fill the order.

One Solution?

While some in the industry say that the issue is overblown, everyone seems to agree that it does exist.

"It (shorting) is an old problem," said Nate Most, chairman emeritus of iShares and the man widely credited with having invented the ETF. "Being able to short is a very important element of this product, and finding a way to support shorting is critical."

Most has been pressing the industry for years to address the problem.While acknowledging that growing in-house positions will help, he said that the system needed to be reformed to make it easier on everyone to find shares to short. It's a need, he said, that will only increase as more small-cap and actively traded ETFs are added to the mix.

"With the smaller ETFs where there are no futures, it's very hard for the smaller houses to hedge positions to create this liquidity," he said. "What we need are specialists who can hedge on a global basis - not on a position-by-position basis, but taking into account their entire portfolio - and then make shares available to all parties on an electronic system."

Ireland had a simpler solution. "The answer," Ireland said, "is for everyone to buy ETFs. Then, we'll never have this problem again."