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2016 | OriginalPaper | Chapter

13. The Long and Short of ETFs

Author : A. Seddik Meziani

Published in: Exchange-Traded Funds

Publisher: Palgrave Macmillan UK

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Abstract

An investment strategy is as good as its ability to take advantage of unusually profitable opportunities or simply reduce exposure to risk. Hence, selecting the right instrument is critical in determining how much success an investor will have with his or her chosen investment strategy. It could be rendered inept by the confines of the instruments being employed to implement it, such as the lack of continuous pricing, the trading restriction of the uptick rule, or any other restrictions that would limit the range of customized investment approaches in which they can be used.

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previous chapter Building Fresh Tax-Advantaged Investment Strategies with ETFs

next chapter Other ETF Investment Strategies and Applications

The uptick rule, or Rule 10a-1(a)(1), subjects listed securities to trading restrictions that state that they may be sold short only above their last traded price. In other words, shares of a security cannot be sold at or below its best bid. The rule is triggered when a security’s price decreases by 10% or more from its previous day’s close to prevent short-selling from further driving down its price.

Exchange-traded funds historically have been exempt from the uptick rule for short sales.

Note that short sellers who use interactive brokers’ platforms are infallibly warned by the platforms’ operators when the uptick rule applies to a specific security, including the dates it is in effect.

Funds based on cap-weighted indexes are generally the largest ETFs, they are the most actively traded, and they generally have the largest short interests.

In practice, a short sale can take place at the last price only if that price was either an increase or not changed at all from the prior trade.

A short squeeze is prompted by a sudden drop in a previously large short interest forcing short sellers to close out their short positions on the stock, usually at a loss. Under such a scenario, short sellers are perceived as being squeezed out of their positions, a situation that produced the expression “short squeeze.”

Most ETF brokers maintain a list of easy-to-borrow securities on their website.

According to SSgA ETF Industry Guide (http://statestreetspdrs.com/711/files/2015/q2/ETF-Industry-Guide.pdf).

To their credit, some of the best short sellers are known for capably identifying problem companies before the rest of the market, as was the case for WorldCom, Enron, and Tyco, to cite a few, all targeted by short sellers before their financial problems came to light.

For more information on the interpretation of short interest, see “Hemang Desai, K. Ramesh, S. Ramu Thiagarajan, and Bala V. Balachandran, “An Investigation of the Informational Role of Short Interest in the Nasdaq Market,” Journal of Finance, 57(5), October 2002, pp. 2263–2287.

http://economics.mit.edu/files/10543

Although it might sound a bit extreme to some, a memorable quote by John D Rockefeller adeptly summarizes contrarian investing: “The way to make money is to buy when blood is running in the streets.”

Days to cover = current short interest/average daily share volume.

Note that these numbers were reported before the pinnacle of the Greek crisis and the recent market selloff. New numbers that have yet to be published could indicate otherwise.

For more information on the subject, see a 2015 report by Deloitte titled “Financial Services Industry Outlooks-2015”: http://www2.deloitte.com/us/en/pages/outlooks/financial-services-industry-outlooks.html.

http://www.proshares.com/funds/euo.html.

A process known as “create-to-lend.”

Most market experts trace the start of the current bull market to March 9, 2009.

http://www.standardandpoors.com.

http://www.wyattresearch.com/topic/blue-chips/.

http://www.aaii.com/journal/article/dividends-are-still-valuable.

Note that the Barclays Aggregate Bond ETF (AGG), 36% of which is U.S. Treasuries, rose 6% during the same year.

“Worth the risk? The appeal and challenges of high-yield bonds.” [https://personal.vanguard.com/pdf/s355.pdf].

This book acknowledges that a growing number of investors take issue with the consensus that high yield is a bond allocation.

https://www.tiaa.org/public/pdf/A326121_406316-High-Yield-Investment.pdf.

Meziani, A.S., D. Ozenbas, and L.V. Portes, “Liquidity under Extreme Market Volatility: The Case of SPY, IVV and RSP Funds,” Financial Decisions, forthcoming Fall 2015.

A. Seddik Meziani, “Russell 2000 Versus S&P SmallCap 600: Beauty is in the Eye of the Beholder,” Institutional Investor Journals, 20(1) (2003), pp. 7–16 [DOI: 10.3905/sp.2003.673846].

104 as of August 06, 2015 according to spdrs.com.

Note that exchange-traded notes (ETNs) are ETFs’ cousins in that they also track an assigned index. The similarities, however, stop there. Whereas ETFs are instruments structured such that their shareholders own a basket of securities, as debt instruments, ETNs don’t own anything but a promise for their investors to track an index. The difference between the two comes down to tracking risk for ETFs versus credit risk for ETNs. Hence, although VXX is provided as an illustration, this book’s emphasis is on ETFs.

Title: The Long and Short of ETFs
Author: A. Seddik Meziani
Publisher: Palgrave Macmillan UK
Book: Exchange-Traded Funds
Print ISBN: 978-1-137-39094-3

Electronic ISBN: 978-1-137-39095-0

Copyright Year: 2016
DOI: https://doi.org/10.1057/978-1-137-39095-0_13