The U.K.’s surprising vote to exit the European Union has many investors reassessing their portfolios, rethinking allocation decisions surrounding Europe. One of the things some may be considering is shorting ETF positions.
There are two main reasons someone might want to short an ETF. To quote Fidelity research, short sales happen either as a hedge to a long “related” position, when investors want to offset some of the risk associated with that position, or because the investor expects the price of that ETF to drop in the near future.
How To Short An ETF
Short-selling isn’t all that common among long-term investors, and the process to short-sell isn’t difficult, but it’s “labor-intensive,” as Fidelity put it.
The fact is that if you want to short, say, a European equity ETF because you believe it will decline in price following the ‘Brexit,’ you would first need to borrow shares of that ETF. That process, known as securities lending, is a widely used practice that contributes to “tighter index tracking and better overall returns,” according to ETF.com research. But it involves some work.
As the investor, you can borrow ETF shares from the issuer, and market makers can make as many shares of an ETF for short-selling as there’s demand for it. You would also have to post collateral to the securities lender and fees—rates that vary depending on the ETF, on how liquid it is, on the lender, etc.
Under the lending agreement, the short-seller would be required then to repurchase these shares at a later date, and replace them with the original owner.
Great Idea With Great Risks
The central idea of short-selling is to sell high, buy low. But there are many risks associated with short-selling. The primary one is financial loss.
“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,” Fidelity research said. “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.”
Despite the risks, an event like Brexit could spark some short-selling activity. Perhaps the cleanest short play in the face of Brexit would be a currency-focused one: shorting the CurrencyShares British Pound Sterling Trust (FXB | B-99).
Following the vote, the British pound declined to a 30-year low, while the U.S. dollar rallied to a three-month high. If these trends hold in place—as many say they should—shorting FXB just might work as the pound declines in value.
FXB exposes investors to changes in the value of the British pound relative to the U.S. dollar through a portfolio that holds physical British pounds in a deposit account.
The fund is very liquid, trading an average of $11 million a day at pretty tight spreads of 0.03%, according to FactSet data. That liquidity makes FXB a prime choice for investors looking to tap into the pound, short or long.
Another interesting currency plan could be to go long the PowerShares DB US Dollar Index Bullish Fund (UUP | B-73). UUP is a bullish bet on the dollar, but one that is built around an inverse exposure. The fund is linked to an index of dollar futures that rises in value as the dollar appreciates relative to a basket of world currencies.
UUP essentially is long the U.S. dollar and short the euro, the Japanese yen, the British pound, the Canadian dollar, the Swedish krona and the Swiss franc. Weakness in any of these currencies relative to the dollar is a boon to UUP.
Consider the performance of FXB and UUP in the last month: