Can An ETF Collapse? No

September 24, 2010

The ETF world erupted Wednesday after CNBC ran a report suggesting that ETFs could lose all their value in an instant due to naked short selling. There’s only one problem: It’s not true.

The CNBC piece reported on a sensationalistic white paper titled “Can an ETF Collapse?,” which was published on Sept. 15 by Bogan Associates, an independent research shop based out of Boston.

The Bogan report examined the case of the SPDR S&P Retail ETF (NYSEArca: XRT), a small ETF that is popular with short-sellers. In fact, XRT is so popular with short-sellers that at one point there were 95 million shares sold short, despite the fact that there were only 17 million shares in existence.

That sounds scary, as Bogan explains, because authorized participants can create or redeem large blocks of ETF shares on a daily basis. “Redemptions occur when more owners wish to sell out of their holding in the ETF than there are new buyers for the existing shares,” writes Bogan, “so unwanted blocks of 50,000 ETF shares each are redeemed through the authorized participants with the ETF operator for cash, or more typically for in-kind shares in the ETF’s underlying index’s stocks.”

What would happen, the report asks, if authorized participants redeemed all 17 million shares of XRT, leaving the other 78 million people who thought they had bought XRT holding the bag.

“Presumably,” the report states, “the SPDR S&P Retail ETF might simply close and cease to exist once its remaining 12 million ETF shares outstanding had been redeemed and all its underlying equity holdings had been delivered to redeeming authorized participants.

It’s easy to see Bogan’s concern.

In fact, it’s so easy to see Bogan’s concern that almost everyone I’ve talked to in the ETF industry has thought about it before. I’ve thought about it; my colleagues here at IndexUniverse have thought about it; other ETF pundits have thought about it; and the people who designed the ETFs in the first place have thought about it.

That’s why this concern is addressed in the prospectus and Statement of Additional Information (SAI) of every ETF I’ve ever looked at. Here’s what it says in XRT’s SAI:

“An Authorized Participant submitting a redemption request is deemed to represent to the Trust that it (or its client) (i) owns outright or has full legal authority and legal beneficial right to tender for redemption the requisite number of Shares to be redeemed and can receive the entire proceeds of the redemption, and (ii) the Shares to be redeemed have not been loaned or pledged to another party nor are they the subject of a repurchase agreement, securities lending agreement or such other arrangement which would preclude the delivery of such Shares to the Trust. The Trust reserves the right to verify these representations at its discretion, but will typically require verification with respect to a redemption request from a Fund in connection with higher levels of redemption activity and/or short interest in the Fund. If the Authorized Participant, upon receipt of a verification request, does not provide sufficient verification of its representations as determined by the Trust, the redemption request will not be considered to have been received in proper form and may be rejected by the Trust.” [Bold added]

In other words, when redeeming shares of XRT, you have to say that the shares aren’t lent out. If there’s high short interest in the fund, you’ll have to prove it, or the redemption doesn’t go through.

Other ETFs go into greater detail. The SAI for the iShares Russell 2000 ETF (NYSEArca: IWM) explicitly states that it will review and potentially reject redemption requests whenever there is either: a) 150 percent short interest in the fund; b) requests to redeem more than 25 percent of the shares outstanding of the fund.

Two things bother me about the whole kerfuffle over the Bogan report. One is that it was reported, unchecked, on CNBC, FT Alphaville and other sites. The other is the hubris of the authors to imagine that they were the first ones to think of this doomsday scenario.

ETFs aren’t perfect. There are a lot of things people should be concerned about, including the fact that ETFs have opened up new and complicated areas of the markets (like commodities) to investors who may not understand how they work. But if we’re going to talk about the challenges of ETFs, we should at least get our facts straight, and check the offering documents before we push white papers out into the world.

For more reporting on this, see Paul Amery’s blog on short-selling in ETFs, “Shorts Running Amok?”, and the news story on Morgan Stanley’s challenge to Bogan.

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