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Don't get caught short

FUNDS: Could short-selling of ETFs lead to problems for UK investors?

Terry Smith, founder of active fund manager Fundsmith and an influential figure in the City, has highlighted the risks incurred if exchange-traded funds (ETFs) are sold short. Short-selling describes the practice of borrowing stock from a third party and selling it to someone else with the intention of buying it back later at a cheaper price to return to the lender. The idea is to profit from a decline in the price between the selling and the buying.

With a company, there is a finite number of shares in issue and available for the short-seller to borrow. But ETFs are a hybrid of a listed vehicle and unit trust. They can, and often do, create new units for big institutional investors. This means that a short-seller could go back to the ETF to buy more shares instead of covering a short position in the market, and could lead to more people holding ETF shares than there are underlying assets in the ETF and actual shares.

This situation has arisen with a popular ETF in the US, the SPDR Retail ETF. At one point last year, the number of shares short on this fund was nearly 95m while the actual shares in issue were 17m. Private investors can only buy ETFs through a broker, not direct from the provider. So there is no way of knowing whether they were from a short-seller.

This exposes you to counter-party risk, as the short seller may not be able to deliver you the shares. Another risk, according to Mr Smith, is that more people want to redeem their shares than there are assets in the ETF, in which case some people would be left holding valueless shares.

ETF provider BlackRock observes that although ETFs' ability to create new shares to cover short positions is not backed by an infinite pool of liquidity, it is easier to cover a short position in an ETF without impacting the underlying market than it is with an ordinary share. There can be other benefits, too: high lending activity for ETFs improves secondary market liquidity for an ETF, resulting in tighter bid-ask spreads.

Not all market experts are convinced that this is a a problem for UK investors. Although there have been high volumes of selling for certain ETFs to date, none has imploded because too many people have wanted to redeem shares. The evidence of shorting so far has largely related to US ETFs; historically, ETFs listed in Europe have not experienced such high levels of short selling.

While ETF shares on loan between 2008 and 2011 in North America totalled $45bn, in the UK it was a mere $671m, and for Europe overall $3.24bn. Even the US figure is a small part of the overall figure: total US equities on loan were $771bn, according to research company Data Explorers.

"Fewer European ETFs are lent and borrowed as European ETFs are used less frequently by hedge funds in their hedging strategies," explains Deborah Fuhr, global head of ETF research and implementation strategy at BlackRock. "Therefore there will be fewer examples of funds with very high short interest ratios."

However, since 2009 there has been a 180 per cent increase in non-US ETF shares on loan, and a 60 per cent increase for those in the US, so the situation could change, albeit from a very low base in Europe.

"What has happened to the SPDR ETF is a pertinent point which people should be aware of," says Mr Urquhart Stewart. "But we haven't seen as much short-selling of ETFs in London yet, so at present this is not a concern."

Another issue for UK investors to bear in mind is that ETFs are often listed on many markets, so if an ETF listed in London is also listed in New York, it could be subject to short-selling via its US listing