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What Short Interest Means For ETFs

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What Short Interest Means For ETFs
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When it comes to individual stocks, rising short interest is usually viewed two ways.

Traditionally, rising short interest is, obviously, seen as a sign that professional traders are bearish on a particular name.

On the other hand, contrarians see single stock short interest as opportunity because if the short thesis is defeated, those borrowed shares to sell short will be forced to cover those bearish positions, sending the stock in question higher in the process.

With exchange traded funds, short interest isn't always this black and white. In fact, there are times when an ETF's short interest can top more than 100 percent of its shares outstanding, which can alarm those that are new to ETFs.

Oil & Retail

Recent data suggest the SPDR S&P Oil & Gas Exploration & Production ETF (NYSE: XOP), one of the largest and most heavily traded equity-based energy ETFs listed in New York, has a short interest of over 126 percent. There have been times when the SPDR S&P Retail ETF (NYSE: XRT) has seen short interest of well over 100 percent of shares outstanding as well. Sounds alarming, but it might not be.

“An ETF with 126% short interest might appear like all shares outstanding have been sold short, its price should decline and the shares outstanding of the fund could be redeemed to zero. In reality, however, short interest can be higher than total shares outstanding and does not necessarily suggest price decline or fund closure. Rather, short interest is heavily dependent upon supply, demand and the ownership reporting chain,” according to a recent note by State Street Global Advisors (SSgA), XOP's issuer.

Sure, some traders short an ETF, XOP in this case, because they're overtly bearish, but others could be short XOP as hedge against long positions in some of the ETF's underlying holdings.

“By taking a closer look at how ETFs trade and their ownership chain, we can see why high short interest in an ETF isn’t an automatic warning sign of fund closure. Let’s say Buyer 1 lends 100 shares of XYZ ETF to Borrower 1, who then immediately sells them short to Buyer 2. Ownership of these shares could temporarily appear on the account records of all three investors, creating the illusion that 300 shares exist,” adds SSgA.

Tracking Error

Critics also assert that massive short interest in an ETF can increase tracking error, or how much an ETF trades away from its underlying index. XOP proves that isn't necessarily the case.

“Yet if we go back to the XOP example, we see short interest changes had little impact on XOP’s ability to track the S&P Oil & Gas Exploration & Production Select Industry Index. During periods of high short interest between 2010 and 2016, performance was within 1-7 basis points of its benchmark,” said SSgA.

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