By Ari I. Weinberg

Everett Interesting shorts

Our story in the recent Funds Quarterly looked at the activity of exchange-traded funds in and around securities lending .

As most Marketbeaters know, lending of both stocks and bonds by ETFs, mutual funds and other institutions is the first step on the way to a short position by another investor. (Other reasons for borrowing securities make up a tiny percent of loans.)

Most exchange-traded funds barely differ from traditional mutual funds in how they lend portfolio securities. In fact, several analysts believe that ETFs are among the most conservative of portfolio lenders. And ETFs set up as unit investment trusts such as PowerShares QQQ, SPDR S&P 500, SPDR Gold Trust and the Merrill Lynch HOLDRS are not actually allowed to lend their underlying holdings.

Where these funds do show up, however, is on the list of the most borrowed U.S.-listed ETFs from Data Explorers, which collects more than 90% of the lending activity from custodians and agent lenders.

Market signal or intellectual curiosity, the list below highlights how ETFs are being used for both macro-hedges (short the S&P 500) or purely sector bets (short retail stocks.) The 28 most heavily-borrowed ETFs in the U.S. accounted for roughly 88% of all borrowing activity in ETFs.

Small and thinly traded ETFs are necessarily less liquid and represent more of a risk for the lender.

The value of U.S. ETFs on loan, $41 billion as of July 6, has quadrupled in a year whereas the global value of equities (including ETFs) on loan has hovered around $800 billion. (At the markets peak in 2007/2008, ETFs on loan approached $60 billion.) This return relative to stock is effectively a signal of increasing use (and lending) of ETFs by institutional investors.

Another list we gathered for the story was of the short interest for NYSE Arca-listed exchange-traded products, including ETNs. About 45 of the listing (out of 1100) had more than 10 days to cover, including more heavily traded PowerShares Aerospace and Defense (23 days), SPDR KBW Regional Banking ETF (17 days) and iShares Russell 1000 Index Fund (11 days). In fact, ETFs often show up in our short interest report .

But looking at ETFs by days to cover distorts one of the more peculiar aspects of the ETF market. Because brokers, known as authorized participants, are able to create and redeem ETF shares, traditional short interest metrics fall apart since the shares outstanding count is not static. For more, read this white paper from State Street Global Advisors on short interest and ETFs .

Sunlight on portfolio lending by funds may be coming, thanks to Dodd-Frank, but the nuances around lending and shorting of ETFs themselves will continue to be hard to divine.