In the last installment of our Mythbusting series, we discussed the practice of lending the securities within an ETF. Now I’m going to tackle the concerns raised in various articles and blogs that ETFs with high levels of short interest can cause a tremendous “short squeeze” for either the ETF itself or for securities held by the ETF. This topic can be complex and there are a lot of moving parts, so I’d like to break it into two posts. Today I’m going to cover what a short squeeze is, and why it’s actually less likely to occur in an ETF than in a single stock. In my next post, we’ll use a specific ETF as a case study to try to show the effects of high short interest in different scenarios.
Before bringing in the concept of a short squeeze, let’s first review the basics. Short selling is a trading strategy in which you sell a security you’ve borrowed from another investor (you’ll have to return the borrowed security at some point in the future). You want the stock to decline so you can sell high, buy low and return the borrowed stock for a profit. As discussed in my last post, the lender hopes to make some income off the loan. Short interest is a measure of the amount of shares that have been sold short and not yet repurchased, often measured either as a percent of daily trading volume or as a percent of the shares outstanding. For ETFs, it tends to be the latter, such that for a $1B ETF, a short interest of 100% would mean a total of $1B has been sold short.
A short squeeze is essentially a situation where a stock’s price is driven up because the demand for a stock suddenly significantly outweighs the supply available. This can occur when short sellers of a security with a large amount of short interest find themselves needing to cover, usually because the market price has begun to rise. Because their potential losses are unlimited, many of these investors will want to purchase the stock to close out their short positions as quickly as possible. What follows is an influx of additional buyers into the market, accelerating the rise in price and causing other short-sellers to close their positions, repeating the cycle. A short squeeze is not an ETF-specific event, but rather something that can happen to any shorted equity security when the price starts to rise.
The main theory I’m hearing out there is that an ETF with high short interest is subject to a short squeeze in the event that the ETF’s price begins to climb and a large number of short sellers are buying to cover their positions. At first glance, I get the concern – a sudden influx of buyers into a security would naturally drive up the price, right? But this theory ignores one very basic but important fact – ETFs, unlike individual stocks, can be continuously created in order to meet supply needs in the market. It is happening all the time – when demand outweighs supply in the market, market makers step in to create more shares of the ETF to meet that demand. Furthermore, since market makers may already have some of the component securities in their accounts before they create, the creation process won’t necessarily cause excess buying pressure on the underlying stocks. I’m going to cover this more comprehensively in my next post, where we’ll examine an ETF with high short interest during periods of significant inflows and outflows.
I’d also point out that, ironically (given the recent fixation on potential ETF short squeezes), ETFs that track broad indices generally will not experience short squeezes to the same extent as an individual security. They tend to be less susceptible to the idiosyncratic market moving news that might significantly affect a single equity, such as the success of a new pharmaceutical drug or a potential merger. For one thing, the majority of broad index tracking ETFs are highly diversified, with regulations dictating minimum number of holdings along with maximum exposures to single securities. So even if there’s a run-up in a single security that a broad-based ETF holds, it likely would not be enough to drive up the price of the entire ETF significantly. Also, a large majority of index tracking ETFs are market cap weighted, which further dilutes price impacts, because the bigger companies (with more shares outstanding) are weighted more heavily than the smaller companies.
So now that we’ve covered the short squeeze issue as it pertains to ETFs in a broad sense, the next step is to address some of the concerns we’ve heard about highly shorted ETFs being at risk for a squeeze. In my next post, I’ll use a specific example as a case study to explore this theory.