Exchange-traded funds are great tools for short-sellers

Section:

ETFs Offer Advantage
for Short Positions;
'Uptick' Rule Not Applied

By Ian Salisbury
Dow Jones Newswires
via National Post (Financial Post), Toronto
Monday, May 14, 2007

NEW YORK -- Exchange-traded funds are known for their ability to accommodate short sellers -- but with some ETFs short selling may be the chief reason for investors' interest.

Stocks often post "short interest," the percentage of shares sold short, of 5 percent or less. Short interest of more than 10 percent is considered high.

Short interest in ETFs can be much higher: A recent report by Morgan Stanley, found that, as of March 31, there were eight ETFs with short interest of more than 100 percent.

The high short interest is due in part to the unusual structure of ETFs, which allows new shares to be created expressly for the purpose of shorting, and in part to their usefulness as baskets of stocks for institutional investors to hedge their market bets.

ETFs resemble index-oriented mutual funds, but trade on an exchange like a stock.

As with stocks, investors can "short" ETFs, a technique allowing them to bet against a particular sector of the economy or to hedge other investments by canceling out bullish bets in another part of their portfolios. Shares are shorted by borrowing them from a brokerage firm and selling them on the open market. The investor hopes to reap a profit if the shares fall in value, when they can be bought back at a lower price.

In some ways, ETFs are even easier to short than stocks. Investors can short stocks only on an "uptick," when the price has recently risen. The regulation prevents bearish investors from piling on when a stock is falling. Most ETFs are exempt from the "uptick" rule.

As baskets of securities, ETFs can be more useful than individual stocks for institutional traders as hedging tools, so interest isn't limited to bearish investors.

Also, while the number of stocks of an individual company that are available to trade is relatively fixed, the number of shares of an ETF fluctuates with investor demand. If a brokerage firm that deals in ETFs sees sudden market demand from short sellers, it can create new ETF share just for that reason.

In the Morgan Stanley study, one fund, KBW Regional Banking EFT (KRR/AMEX), had short interest of a whopping 3,676 percent on March 31. That number implies that shares of the tiny fund -- it had US$9 million in assets at the time of the study -- had been lent and re-lent more than 30 times. Morgan Stanley reported the short interest on April 24 at lower, but still vertiginous, 1,838 percent.

The bearish interest in the regional banking ETF may be from investors who hoped to capitalize on problems in the U.S. subprime mortgage industry. It could also reflect investors moving short bets from a larger regional bank ETF into the small KBW Regional Banking ETF.

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