The short selling strategy has gained mainstream attention in the past two weeks, when investors rushed to buy GameStop shares, triggering an epic selling squeeze. But while a troubled company like GameStop or AMC Theaters may seem like the most obvious target for short trading, there is an even more attractive target: exchange-traded funds.
Following ETF leaders
The SPDR S&P Biotech ETF is an industry-specific index fund with stakes between biotechnology companies. Despite a return of more than 83% in one year, the ETF SPDR Biotech had a 102% stake sold on February 1, among the highest of all securities traded on all exchanges. (An ETF may have over 100% short interest when the number of shares sold is much higher than the number of shares that were issued. It is usually an indication of leverage from the hedge fund.) Short interest on the ETF has fallen to 98% today. In comparison, the stake sold in Gamestop shares on January 27 was 88.6%.
“Some people are really putting their money where their mouth is, when expressing their predictions,” said Lisa Kramer, professor of finance at the University of Toronto.
ETFs: less risky by design
An ETF is a specific type of index fund that tracks a series of underlying investments in a particular industry or market segment. ETFs allow institutional and retail investors to hold parts of multiple investments at the same time, instead of focusing on a particular company or asset type such as gold, allowing investors to diversify and reduce their financial risk. ETFs have predefined rules; they trade throughout the day on public exchanges; they are often run by major financial companies like Fidelity, BlackRock and Vanguard; and are popular due to their low costs, greater flexibility and tax benefits compared to mutual funds. The ETF industry grew to more than $ 5 trillion during the pandemic, fueled by $ 400 billion in new investments, low Federal Reserve interest rates and investor optimism about an economic recovery later this year.
Experts say buying short positions in index ETFs like these is a way for traders to reduce risk in an investment portfolio. the Wharton School of Administration at the University of Pennsylvania.
Greater than the sum of what is issued
Short interest rates on an ETF can increase to more than 100% because an ETF issued share can be borrowed and lent more than once. Each time this process takes place, it increases what is known as “long and short open exposures”, but does not increase the number of shares outstanding. Short selling is often done by hedge funds that seek to protect an existing bet that another stake in your portfolio will increase in value.
Roussanov said it should come as no surprise that there are more short sales of ETFs, on average, than individual stocks because of the creation and rescue process behind them.
Large financial institutions, known as authorized participants (APs), can request the creation of new ETF shares and also redeem ETF shares for the underlying securities. When the value of an ETF is higher or lower than the underlying securities, an AP can intervene by making transactions that bring the price of the ETF back to its fair value. This process can trigger changes in the number of short positions and shares in circulation very quickly and in both directions daily.
“The size of the fund goes up and down because it adjusts relatively easily to the buying and selling pressure in a way that the number of outstanding shares of an individual company would not be able to do,” said Roussanov.
Gamestop impact
One ETF in particular has seen huge swings in the past two weeks. The stake sold in the ETF SPDR S&P Retail rose above 600% on January 27, mainly because GameStop was among its stakes.
The retail ETF has the same weight in design, which means that each of its 95 holdings generally does not exceed more than 1.6% of its total assets under management. That changed when the price of Gamestop skyrocketed to more than $ 460 on January 28, increasing the company’s weight in the fund to 20%. Retail ETF holdings were suddenly in high demand due to GameStop’s momentum, according to Bloomberg Intelligence. This led to an increase in trading and an exit of more than $ 506 million on January 28, after the APs redeemed ETF shares. This bailout helped to increase the number of Gamestop shares in circulation, but it also drained most of the ETF’s assets.
Not for beginners
Experts say the “extreme level of agility and discipline” needed to manage short selling means that this high level of short interest in these ETFs comes mainly from hedge funds and private equity funds, not from new retail investors who recently invested in applications like Robinhood. Since short selling is primarily a momentum and short-term trading strategy, it is different from conventional investment, which is more about holding securities for a long-term period.
Sara Walker, a senior strategist at BMO Wealth Management, considers short selling to be such a speculative strategy that she tells her clients that it should only be done with “crazy money”, a specific pool of funds that someone can afford to throw away. “Remember: there is a limit on the positive side, which means a limit on the money you can earn, but not on the money you can lose.”