Was last month’s broad decline in short interest a sign of a QE2-addled market?

A broad decline last month in short interest in the biggest and most widely traded ETFs suggests investors are taking on risk more decisively than they have in the recent months. It’s still too early to tell whether the decrease is related to the Federal Reserve’s easy-money policy, a sign of renewed economic recovery or something else entirely.

The numbers, however, are clear: ETF investors are peeling off short bets aggressively.

The number of shares of the SPDR S&P 500 ETF (NYSEArca: SPY) being shorted fell almost 8 percent last month, on top of a 12 percent decrease in September. The number of shares of the world’s biggest ETF that are short amount to just over a third of its outstanding shares. That equals a $33.4 billion bet against U.S. large-cap equities.

As the “Big Bets” table below shows, the decline in SPY shorting was the tip of an iceberg.

Most notably, the iShares MSCI Emerging Markets Index Fund saw a 22 percent decline in shares short. Just 3.5 percent of EEM’s outstanding shares are short, compared with 4.6 percent at the end of September. Emerging markets have been on a tear this year, all the more so since financial markets saw dollar weakness in the Fed’s plans and accelerated movements into developing markets and gold.

The Fed announced its latest “quantitative easing” efforts to stimulate the economy on Nov. 3.  The central bank said it plans to spend about $600 billion, or $75 billion a month, on Treasurys, essentially with borrowed money. It hopes the plan—"QE2" in market parlance—will spur economic activity by keeping yields lower and, theoretically, encourage borrowing.

The drop in short interest extended to the SPDR S&P Retail ETF (NYSEArca: XRT), a lightning rod of a fund in the ETF world. XRT is heavily favored by traders—and short-sellers. The number of XRT shares being shorted fell 4.2 percent last month after falling almost 25 percent in September.

Still, the number of XRT shares short is almost five times the number of outstanding shares, and that’s where the controversy surrounding the fund starts. Critics have seized on this eye-popping figure, saying XRT and other funds like it with heavy short interest could collapse under the weight of the sheer number of investors betting against them.

Of course, what people (such as the ones who wrote the Kauffman Foundation report this week) fail to realize is that shorting ETFs is very different from shorting individual stocks. An ETF short-seller can have an authorized participant create the shares necessary to cover a short.

Our “Really Really Short" list below highlights this quirk of the ETF world. All the funds have short interest that either exceeds or comes close to the number of their outstanding shares.

For the record, XRT is no longer No. 1 on the short interest list. In its place is the SPDR S&P Oil & Gas Exploration & Production (NYSEArca: XOP). The number of XOP shares being shorted rose almost 7 percent last month to a number that’s seven times as large as its outstanding shares. In September, the number of shorts in the fund rose 30 percent.

Measuring short interest in ETFs is an easy way to measure investor sentiment in large segments of the market, but one must be careful when interpreting the data.

While investors do use ETFs to take macro short bets on the markets, shorts can represent alternative strategies as well.

One popular market-neutral strategy, for instance, is to go long a basket of favored stocks and then short the accompanying ETF, neutralizing your market risk and allowing the single-stock performance to shine through.

Data is believed to be accurate; however, transient market data is often subject to subsequent revision and correction by the exchanges.