Assessing the Risks of an ETF 'Blow up'

02/02/2011 2:22 pm EST

Focus: ETFS

John Heinzl

Reporter and Columnist,

Fears that ETFs are unstable and prone to collapse are unfounded, says John Heinzl, reporter and columnist for

“We were getting multiple calls a day. Some from retail investors and some from institutional investors with responsibility for very large pools of money, some from advisers, across the whole spectrum,” Mr. McMahon said.

Why are ETFs, which have experienced phenomenal growth in recent years, suddenly the focus of so much anxiety? Blame it on a pair of US reports that suggest ETFs—essentially mutual funds that trade like stocks—are inherently unstable and prone to collapse.

According to one report, by Bogan Associates of Boston, the risk is especially acute for ETFs with large short positions. If enough ETF shareholders tried to sell their units at the same time, a highly shorted ETF would be unable to meet all the redemption requests, triggering the collapse of the fund—or so Bogan Associates argued.

Scary stuff, for sure. But today we’ll show why such fears are unfounded and arise from a misunderstanding of how ETFs work.

“IShares ETFs cannot blow up. I’m happy for you to quote me on that,” Mr. McMahon said. “We’ve spent 20 years designing them and we have thought about everything we possibly could that could go wrong with an ETF and designed them to make sure something like this can’t happen.”

You don’t need to take Mr. McMahon’s word for it. Many others have debunked both the Bogan report and a similarly scary paper by the Kauffman Foundation of Kansas City, Mo.

The debunkers include Credit Suisse, which in January published a research note titled “ETF Mythbuster: Can a Highly Shorted ETF Collapse?,” which showed why such fears are unfounded.

Short Positions

The first thing you need to know is that some ETFs do indeed have large short positions. In some cases, the number of short positions even exceeds the number of ETF shares in existence. This is because ETFs are a convenient hedging tool for arbitrageurs, hedge funds, and other sophisticated investors. By going long with one security, and shorting an ETF (essentially betting the price will fall), these investors attempt to manage their risk.

“This explains why ETFs generally have a higher percentage of shares shorted than regular stocks,” Credit Suisse analysts Victor Lin and Phil Mackintosh said in the report.

What is a short position, you ask? Consider stock XYZ that is selling for $1. If an investor believes the price of XYZ will fall, he can borrow a share of XYZ from another investor, for a small fee. After borrowing the share, he can then sell it in the marketplace, pocketing $1 in cash. This investor now has $1 but is “short”—that is, owes—one share.

If the price of XYZ subsequently falls to 75 cents, the investor who is short can then buy back the share in the market and return it to the original owner. Since he spends just 75 cents to repurchase the share, he makes a profit of 25 cents.

Why Fears Are Unfounded

Now here’s a key thing: A single share of XYZ can be borrowed and sold short multiple times. So the number of short (and long) positions can continue rising, even if there is just one ETF share outstanding. This is why some people worry that, in the event of a large number of redemption orders, the ETF provider would not have enough assets backing the ETF to meet all the requests.

But as Credit Suisse points out, the fears are unfounded, because with a highly shorted ETF a large redemption order would trigger a recall of lent stock. The borrower of the stock would then need to either a) purchase the shares in the open market, or b) borrow them from someone else. In both instances, the additional demand for the shares would be satisfied by arbitrageurs who can create units to meet the extra demand. These arbitrageurs—who profit from slight differences between the ETF price and the price of the underlying assets—create additional units by acquiring the relevant basket of securities and delivering it to the fund, in exchange for new shares.

It’s a complex process, but the important thing is that “at the end of the day, the ‘creation’ of units would return assets to the ETF provider, boosting the shares in the ETF fund, ensuring it still has assets to back remaining investors,” Credit Suisse says.

Bottom line: ETFs “can’t blow up,” Mr. McMahon said. “It’s a fundamental misunderstanding of the product, which is a bit disappointing.”

In fact, ETFs are fundamentally no different from stocks, he said. The problem is that they are relatively new products, and investors are still trying to wrap their heads around them.

By all means consider the risks before buying an ETF. Are the underlying assets appropriate for your risk tolerance and time horizon? Do you understand exactly what you’re investing in? Are the management fees reasonable? These are questions you should ask before buying any investment.

But don’t waste your energy worrying that the ETF itself will collapse; it won’t.

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