about a common stock in the context of short selling, who owns the
ETF shares outstanding should not matter very much to the ETF investor
or to the risk manager who would sell ETF shares short. The opportunity
to increase ETF shares outstanding, literally at a moment’s notice,
makes current ETF shares outstanding largely irrelevant from a trading
or risk management perspective. Nonetheless, knowing something
about the composition of the shareholder population and the effect of
short sales on share ownership can help traders better understand the
ETF market and ETF share-borrowing and -trading costs.
A typical large-capitalization common stock without significant
insider holdings may show institutional investors accounting for 70% to
80% of its share capitalization. This institutional shareholder data can
be accumulated from 13-F reports and similar filings with the Securities
and Exchange Commission. The institutional share of ETF ownership
varies widely among the funds, but most ETF 13-F summaries show
institutional shareholdings in the 20–40% of ETF capitalization range,
far below the institutional holdings in most of the U.S. common stocks
held by the typical ETF.
When the ETF institutional shareholder numbers are viewed relative
to the typical large ETF’s short interest, the relatively low ETF institutional
ownership is almost surprising. With the short interest running
about 2% of shares outstanding in the average common stock, it is not
important that 2% of shares may be reported twice because one institution
has lent its shares to a short seller and the shares have been purchased
by another reporting institution. With a two percent short
interest, double counting all or part of the short interest in the 13-F
reports does not affect the reported institutional ownership of most
common stocks very much because the short interest is such a negligible
part of the total stock capitalization. However, the large short interest
in many ETFs affects the reports considerably because all shares that
have been sold short appear as long positions in two investor portfolios.
Consequently, the ETF institutional ownership percentage reflected in
the 13-F reports is overstated as a percentage of total shares. For example,
if the short interest is reported at, say, 55% of capitalization, the
number of shares shown on the books of all holders of the ETF’s shares
will total 155% of the number of shares outstanding. If the 13-F reports
show that institutions hold 45% of the shares outstanding in the ETF,
that is actually 45% out of 155% or only about 29% of the shares that
all investors combined show long in their accounts.
Huge ETF short interests also mean that short sellers play important
roles in the size of an ETF’s assets and in its trading activity. Specialists and
other market makers have frequently maintained significant inventories of
ETF shares to lend to short sellers. These market makers hedge their positions
and obtain a fee from the securities lending operation, making creation
of ETF shares for securities lending a modestly profitable business
activity at times. In the summer of 2003, many market makers substantially
reduced these ETF lending positions, apparently because interest rates were
so low that ETF share lending was no longer profitable for them.
The departure of some dealers from the business of buying and
hedging ETF shares for the securities lending market has not led to a
shortage of shares available to short sellers.11 As the increase in many of
the short interest percentages (SIPs) in the largest ETFs listed in Exhibit
4.2 suggests, the ETF share borrowing needs of short sellers have been
readily accommodated by institutional ETF holders, by brokerage firms
carrying retail margin accounts and by other dealers. When market
makers reduced their participation in the ETF share-lending business,
they redeemed the shares they had been lending. This reduced the funds’
shares outstanding, but had no negative effect on the short interest that
actually grew in most large ETFs. In fact, the same lower interest rates
that reduced the attractiveness of ETF share lending to market makers
also reduced the effective cost of ETF borrowing and short selling by
risk managers. The reduction in the cost of borrowing ETF shares made
ETF short sales more attractive relative to short futures positions in
comparisons like those illustrated in Exhibit 4.1. Consequently, short
ETF positions gained risk management market share from short-stock
index futures positions.
With or without market makers’ ETF-lending portfolios, substantial
numbers of ETF shares have been made available to short sellers by
institutions and by brokerage firms from their retail investor accounts–
which typically exceed the size of institutional ETF holdings. Broker-
dealers, both in their roles as market makers and for their own risk
management operations, are also substantial holders, lenders and short
sellers of ETF shares. There is little published data to help us quantify
all these participations.
Read More : Who Owns ETF Shares?
