The recent report by Bogan Associates that caused so many heads to spin across the ETF industry was focused primarily on the evils of short selling and, as far as that goes, was wildly off the mark and highly irresponsible.

In his misguided efforts, Andrew Bogan, a money manager in Boston, used the SPDR Retail ETF (NYSEArca: XRT) as the ultimate example of what’s wrong with ETFs. Bogan argued that the fact XRT has so many more shares sold short than its long shares outstanding should be a serious cause for concern for investors, regulators and believers of an efficient market. He’s off the mark, and I’ll tell you why.

His argument betrayed a basic misunderstanding of how short selling in ETFs works, and created a lot of unnecessary anxiety among investors.

That’s why I’m taking the time to give Bogan, and anyone else who feels they need it, a primer on short selling ETFs. The lesson is simple and has three parts: ETFs were designed to be shorted; a large short interest in an ETF isn’t the same thing as naked short selling of an ETF or individual stock; and Bogan does a disservice to readers by failing to try to understand what motivates someone who shorts an ETF.

Born To Be Short

ETFs from Day 1 were designed as hedging tools from the short side. That’s in addition to providing long exposure to some broad-based or sector index, or specialized asset segment.

On any given day, a number of ETFs will have a higher short interest than their shares outstanding and there’s nothing wrong, abnormal or illegal about this. It’s simply a function of supply and demand within the framework of market structure. It’s very feasible for an institutional manager who is a “stock picker” by nature to short a sector ETF to manage risk against his long holdings, making himself in essence “delta neutral.”

XRT is a fine example of a sector ETF that at times may be more popular among short-sellers than long buyers simply because institutional investors are using it for a hedge.

Crucially, that’s not because they are doing something sinister, and defrauding their prime brokers ultimately to lead to the collapse of the ETF and leave someone “holding the bag,” as the Bogan article states. Hysteria anyone?

It’s Not Naked Shorting

Just because an ETF has more shares shorted than long shares outstanding, doesn’t in any way mean that the fund sponsor cannot track, or is somehow unaware of, the existence of this short interest. In fact, high short interest does not imply “naked short selling.” Naked short selling refers to short selling an equity or ETF without first securing a “borrow” on that security through your prime broker.

Regulators fiercely cracked down on naked short selling beginning in 2008, and rest assured that the differential of 78 million shares of XRT that existed as shorts above and beyond the long shares outstanding were not “naked shorts.”

The fund sponsor, SSgA, as is any fund sponsor, is fully aware of the shares shorted within their fund families.

In the case of XRT—which represents a robust U.S.-based retail index that includes underlying equities such as Priceline.com, Expedia, Family Dollar Stores, AutoZone and Monro Muffler—if demand for short shares outstrips the number of long shares outstanding, then a “create to lend” market kicks in. It has everything to do with the availability and liquidity of the underlying constituents of the index that the ETF is based on.

If the underlying constituents become so heavily shorted that they become “hard to borrow” or “impossible to borrow,” new shorts can only be facilitated through naked short selling. Should the supply of underlying securities in an ETF become that tight, and short interest continues to rise, then the industry and regulators have a real reason to be concerned.

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