Morgan Stanley Challenges “ETF Collapse” Theory

September 24, 2010

Matt Tagliani, head of European and Asian ETF product at Morgan Stanley in London, has challenged the theory of an ETF collapse caused by the lending and short sale of ETFs.

The theory, promulgated by Bogan Associates, LLC in a 15 September white paper entitled “Can an ETF Collapse?” was publicised in a subsequent FT Alphaville blog and then featured as the topic of a CNBC strategy session on Wednesday this week.

According to Herb Greenberg, senior stocks correspondent at the US business channel, “many critics are concerned that ETFs have grown well beyond their original intention and have become a monster that will wreak havoc.”

Bogan’s report focuses on the example of the SPDR S&P Retail ETF (NYSE: XRT). According to the report’s authors, Andrew Bogan, Brendan Conner and Elizabeth Bogan, 95 million shares of the ETF were recently sold short, while only 17 million shares of the fund were in actual issuance. This, according to the authors, “creates a serious counterparty risk and quite possibly the potential for a run on an ETF—where the assets held by the fund operator could become insufficient to meet redemptions.”

Furthermore, say the authors, a short interest in excess of the shares in issue means that there is “naked shorting” going on. Naked shorting, which is banned in most countries, is generally taken to mean that a stock or ETF is being sold short without the seller actually being able to borrow it.

According to Tagliani of Morgan Stanley, however, the ETF collapse debate is misleading.

In particular, there’s nothing unusual in the fact that the short interest in an ETF is greater than the number of shares outstanding, says Tagliani. While such a situation is uncommon for regular stocks, it occurs frequently with ETFs, he says, since exchange-traded funds are often used as hedging instruments, and the shares outstanding in the fund changes regularly due to creations and redemptions.

Neither does an ETF short interest that exceeds the official tally of shares in issue mean that “naked” shorting is occurring, argues Tagliani. “Short interest exceeding outstanding issuance absolutely does not imply naked short selling. When an investor buys an ETF, regardless of whether the seller is long or short, those shares must exist in order to pass through the settlement systems. If the buyer then chooses to redeem the shares, then the shares do cease to exist, but the one who decides is the buyer, not the seller.”

The “recall” risk that exists with a stock, where lenders can recall their lent shares at any time, potentially causing a “short squeeze” or price spike in the relevant security when there are large volumes of short covers, isn’t really a concern for ETFs, says Tagliani. Unlike regular stocks, ETFs can be created on demand by broker dealers, he says, meaning that it’s easy to increase the tally of shares outstanding to meet any temporary imbalance in demand. What’s more, he points out, a short squeeze is only painful to the short sellers – the long holders benefit from the price increase.

Finally, asserts Tagliani, the risk that those holders of an ETF that are not involved in share loan transactions might redeem all their shares, leading to the fund closing while there are still long and short positions outstanding, is not a real risk at all.

“Under the terms of the authorised participant agreements signed between issuers and brokers, the issuer usually has the right to refuse a redemption for a period of time if it would be disruptive to the fund. The authorized participant would be told that they could not redeem the entire position but would be required to leave a small number of shares outstanding to allow the fund a few days to resolve the situation in a fair and orderly manner for all parties,” says Tagliani.



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