About two weeks ago a small research firm in Boston, Bogan Associates, published a piece titled “Can an ETF Collapse?”. It basically argued that because some (US-based) ETFs are heavily shorted, in a market crisis the fund sponsors may stop redeeming fund shares as there have been many more ETF shares created through short selling than have been actually covered through underlying equities by the sponsor.
CNBC’s Herb Greenberg picked the story up and the report was also published on Seeking Alpha, an influential financial blog. Within hours a storm broke loose in the blogosphere but also mainstream media found themselves in heavy debate whether it was possible that the whole ETF market can face an Armageddon-like meltdown scenario. Morgan Stanley in London voiced that the Bogan report was actually bogus and IndexUniverse, an Internet platform mainly concerned with index investing, also criticized the doomsday scenario. Leading fund research firm Morningstar had to put out a long article that explained the mechanics of creating and shorting an ETF in order to highlight that it was impossible for an ETF to collapse via its short interest.
So what is our take? It seems that heavy short selling of ETFs is mainly a US problem and the severe cases are limited to a few specific funds. Also, given the market mechanics of shorting, that kind of scenario should mainly create problems for the shorters (”short squeeze”) but definitely not for the regular long-only retail investor. Yet, undoubtedly the whole debate shows that the rapid growth in ETFs has created some market practices that should be monitored very closely by market participants and financial authorities. We are convinced that ETF risks are not in the shorting of an ETF but in various other market developments we have highlighted in a recent report on ETF risks.