Nadig: The Craziest ETF Short

Can investors shorting IYR find a happy ending?

Because of the creation/redemption process, a liquid ETF has an enormous capacity to absorb short-sellers. After all, if there’s not enough of a given ETF to serve as inventory for shorting, an AP can just make more. That’s not the case with individual stocks.

We also live in a world where more and more investors are expressing their opinions not on individual stocks like Twitter and Apple, but on China or the shape of the yield curve.

Or, say, real estate.

In case you’ve missed it, U.S. real estate has been on a tear lately. You can see it pretty clearly in the chart of the iShares U.S. Real Estate ETF (IYR | B-94).

Chart courtesy of StockCharts.com

After recovering from a death-defying plunge in 2011, IYR has run from the low 40s to a high last year of over 72. The story for the last year has been much more nuanced, but 2014 has been nothing but a bull run.

For REIT wonks, it’s been a perfect storm. There’s been genuine demand for commercial, residential and specialty real estate, but not so much demand that developers have reacted with significant new capacity. That means prices and rents for existing properties—the kind owned by the firms held by IYR—have been doing very nicely.

On top of that, we’ve seen the investment community piling in, further building a bit of a froth on REIT and REIT ETFs. In fact, Gallup published a poll last week in which individual Americans called real estate the best long-term investment:

Whenever I see an ETF running in frothy waters, I ask myself one more question: How are the shorts doing? It’s not like I’m the only person on the planet following how prices move and reading Gallup’s PR Newswire. The latest short data we have on IYR is from April 15, and the results were a little surprising:

Source: Bloomberg

A few things to note here. First, the absolute shares short in IYR are at all-time highs, over 97 million. So how important is that? Well, to put it in context, that’s 146 percent of all the existing shares in IYR.

Yes, you read that right. Every share in existence of IYR is currently out on loan 1.5 times. For ETF investors unused to how shorting works, that’s not actually impossible, due to cascading shorts.

If I own 100 shares of IYR, I can loan that to you. You then sell them short on the open market, and report those 100 shares as “short.” Those 100 shares are now 100 percent short. But whoever you sold them to can also turn around and loan them to a short-seller as well, putting those 100 shares now 200 percent short.

It’s not the house of cards it might seem. At any given point in time, only one person has “unencumbered” claim on those 100 shares—the last person who bought them. If I decide I want my shares back, I recall them, and the whole process unwinds, with a lot of people having to buy back shares in a hurry. That’s called a “short squeeze.”

And short squeezes in ETFs, which often end up “overshort,” can be particularly quick and brutal. That’s what makes IYR, for my money, just about the scariest short in ETF land right now.

I see the reasoning behind shorting the current real estate rally: The economy is hardly going gangbusters, prices can’t stay high forever without supply coming online, and investors have bid prices up. But shorting IYR today, into a market already 145 percent short, strikes me as a recipe for a short-term disaster. On top of this, IYR currently has a yield of over 3.5%—that's a straight-up cost for shortsellers, and a significant headwind if you plan on shorting for anything but a lightning trade.

There are really two outcomes for IYR shorts at this point. Either the pain of being wrong gets so bad they buy back in and cover their shorts at a loss, pushing up prices further, or the REIT market corrects enough for all these new shorts to book their profits, causing any downdraft to be cut off as the shorts come into cover.

Either outcome puts a damper on the prospects for the short-sellers. It doesn’t even matter that they may be right. In the immortal (possibly misquoted) words of John Maynard Keynes, the market can remain irrational longer than you can remain solvent.

At the time this article was written, the author held no positions in the security mentioned. Contact Dave Nadig at [email protected]. Follow him on twitter: @DaveNadig.