Most investors will rarely, if ever, consider selling shares of an ETF short as part of their investment program. However, short selling in the ETF marketplace is a large part of ETF trading volume, and ETF short positions are often so large relative to total ETF shares outstanding that the investor who does not understand the effects of short selling on his ETF position risks (1) paying unnecessary taxes on ETF dividends, (2) misunderstanding the significance of ETF market statistics, (3) missing the best way to take some positions, and (4) missing some unusual but attractive investment opportunities. Before addressing these problems and opportunities, it is useful to take a careful look at the risks associated with selling ETFs short, in order to put things in perspective.

Risks

Short selling itself is an activity undertaken for two primary reasons. The investor or trader wants to hedge using a short sale of a particular security against another position, or they expect the share price of the ETF to decline. Short-sellers hope to sell shares at a high price today and use the proceeds to buy back the borrowed shares at a lower price sometime in the future in a bid to profit. This requires borrowing shares from one owner with an agreement to replace those shares via a future repurchase.

The central danger of short selling is that a trader or investor’s potential loss, or downside, is unlimited because share prices can rise infinitely. With a long position, the investor is risking only the amount that he or she spends. In a short sale, losses can accumulate far beyond an investor’s original expectations.

Anyone who has wandered by video monitors in the windows of a ski or surf shop has seen dramatic pictures of skiers or surfers in obvious peril. A skier jumps from the edge of a cliff above the camera and disappears from view with no apparent chance of survival—until the scene cuts to another camera showing a safe landing on a 55-degree slope. Extreme skiers lack obvious exit strategies.

At first glance, it might appear that an investor who sells ETF shares (or any other shares) short is taking risks similar in magnitude to those of these extreme ski enthusiasts. When we understand that the short interest in the average U.S. common stock is less than 2 percent of the stock’s capitalization, while the short interest in ETFs often ranges from 20 percent to as much as several hundred percent of the ETF’s outstanding shares, the comparison of ETF short sellers to extreme skiers seems especially apt. However, the risks associated with ETF short selling are more in line with the risks taken by a competent skier cruising on a recently groomed intermediate trail. The ETF short seller, like the cruising skier, has to be alert and follow the rules, but the risks are clear and readily manageable. Here’s why:

It is nearly impossible to suffer a short squeeze in cap-weighted, float-adjusted equity or fixed income index ETF shares. Most of the major benchmark indexes that serve as the basis for futures contracts and the other components of an index arbitrage complex are cap-weighted, usually with float adjustments. The funds based on cap-weighted indexes are generally the largest ETFs, they are the most actively traded, and they generally have the largest short interests. The opportunity for any significant weighting problems leading to a short squeeze in any of these ETFs is remote. ETFs using other weighting systems are typically small, but they have fully adequate short squeeze control features. There are a variety of weighting schemes in use for some of the custom indexes developed for ETFs in recent years. None of these weighting approaches is likely to lead to a short squeeze.

In contrast to the short sale of a stock—where you have to deliver the exact shares you sold short—the ETF portfolio may change between the time you short the ETF shares and the time you buy them back. The portfolio manager of an ETF will usually want to protect the investor (and the fund) from a short squeeze in one of the fund’s portfolio securities by limiting additional purchases of that security if the security would become too large a part of the fund’s portfolio. The rules for ETF management offer plenty of protection from a squeeze on a small position in the ETF portfolio. ETFs can lend their portfolio securities to Authorized Participants who want to create more shares. These securities loans are subject to SEC-imposed limitations on the percentage of a fund’s total holdings that can be loaned, but the whole process is designed to reduce the risk of a short squeeze.

Why Sell Short?

Most ETF short sales are made in essentially cap-weighted benchmark index ETFs and they are used to reduce, offset, or otherwise manage the risk of a related financial position. The dominant ETF short sale transaction offsets all or part of the market risk of a related long position. The upside risk of any short sale is theoretically greater than the downside risk of a (long) purchase, but the upside risk of the short position is reduced by the way most ETF short sales are used in arbitrage-type transactions to offset other risks. For example, a small-cap stock manager may sell shares short in a small-cap ETF because that fund tracks an index that is easy for active managers to beat. The diversified ETF shares will usually exhibit a less volatile performance pattern than an active portfolio. The combination of the long and short positions will usually be less volatile than the volatility of either position separately.Unlike the aggressive skier or surfer, the risk manager who sells ETF shares short is nearly always reducing the net risk of an investment position. The managers selling ETFs short are using the short position like the ski patrol or lifeguards at the surfing beach: they sell ETFs short to reduce the total risk of their activities.

ETFs also provide a benefit in regard to their ease of entry. Since ETFs do not have uptick rules, investors can short if the market is trending down. This means the investor can short shares aimmediately enter into the short position, instead of waiting for a rise in price.

Short Selling ETFs

Securities borrowing and lending is a labor-intensive process by securities industry standards. However, exchange-traded fund shares can be created in nearly unlimited quantities. Market makers in ETFs will readily create shares in most ETFs for the express purpose of lending the shares. If shares must be created to lend, the cost of borrowing them will be slightly greater than the general collateral rate that would apply to the loan of an S&P 500 component stock. Any added cost to borrow shares in an ETF will be a function of the effect of the fund expense ratio on the securities lender’s costs. Rates may vary, depending on the natural availability of shares to lend in a specific ETF. Even with the effect of the expense ratio if shares must be created to lend, ETF shares are neither hard nor expensive to borrow.

Most investors are interested in improving the performance of their own investment portfolio through the intelligent use of ETFs. Few are candidates to become arbitrageurs. Nonetheless, all investors will use ETFs more effectively if they understand the significance of short selling ETFs.