New SEC rules could boost short ETFs as trading volume surges
By John Spence
Sep 18, 2008 14:31:00 (ET)
BOSTON (MarketWatch) -- Securities and Exchange Commission rules that went into effect Thursday designed to stop "naked" short selling could prove to be a boon for a rapidly growing segment of the market for exchange-traded funds.
One of the controversial new rules requires short sellers to actually borrow company shares before selling them. In a naked short sale, the seller doesn't arrange to borrow the stock, which can intensify plunges in the share price.
Traders who short stocks sell the borrowed stock, making a bet the price will go down and it can be bought back in the future. The profit comes from the price difference.
The SEC said it is concerned "about the possible unnecessary or artificial price movements based on unfounded rumors regarding the stability of financial institutions and other issuers exacerbated by 'naked' short selling." The agency is also considering a rule that would require hedge funds to disclose their short positions.
However, the more stringent rules on short selling could drive interest in ETFs that allow investors to conveniently short entire segments of the market. The funds use derivatives and other financial instruments to deliver short exposure and leverage.
Naked short selling has become an explosive issue during the storm in financial and credit markets, and the SEC moved to act after Lehman Brothers fell into bankruptcy and American International Group Inc. (AIG, Trade ) required a government rescue.
ProShares and Rydex Investments are ETF managers that oversee bearish funds that give the opposite daily return of market indexes, minus fees and expenses. Some of these ETFs also pile on leverage, which magnifies their volatility and results in bigger gains and potential losses for investors.
For example, ProShares UltraShort Financials (SKF, Trade ) is an ETF that gives leveraged, short exposure to the financial sector. Essentially, it gives twice the inverse (opposite) of the daily return of the sector.
Therefore, if the tracking index lost 2% during a trading session, the ETF should rise roughly 4%. However, over longer periods, the returns may vary due to fees, borrowing costs and compounding returns.
The fund has seen its trading volume spike this week as the credit-fueled problems in the financial sector have come to a head and some of Wall Street's largest institutions have disappeared overnight. Launched in early 2007, the ETF's daily volume broke through 70 million shares for the first time Monday, and again on Wednesday.
ProShares UltraShort Financials traded higher in midday action Thursday and was up more than 30% for the week.
ProShares Chairman Michael Sapir in an interview Thursday said the ETF saw its volume bump up earlier this summer when the SEC put a temporary rule in place geared to prevent naked short selling of key financial institutions.
He said the new rules, which apply to all stocks and not just certain financial companies, "make shorting even more complicated and difficult."
Short-selling ETFs allow investors to hedge against losses or profit from market declines without borrowing the underlying stocks. Traders can also get leverage without setting up a margin account. Finally, short sellers can suffer unlimited losses if the stock rallies, while investors in leveraged and short ETFs can only lose their entire initial investment -- it can't go below zero.
Although ProShares runs 64 ETFs, ProShares UltraShort Financials is its largest offering, and assets have broken through $4 billion at times even though the fund is less than two years old.
Until July when the SEC's temporary naked-shorting prohibition went into effect, ProShares UltraShort Financials had seen average daily trading volume of about 12 million shares, according to Sapir. Since then, it has averaged volume of more than 40 million shares, although with accelerating credit crunch, "it's hard to isolate cause and effect" regarding short-selling regulations because of all the market action and panic in financial stocks.
In any case, Sapir said ProShares has seen massive trading volume this week amid the wild swings in the stock market. On Wednesday, investors traded 410 million shares of all the Bethesda, Md.-based firm's products. In dollar terms, about $30 billion of value traded in one day, which is more than the combined assets of the company's ETFs.
ETF trading volume has surged this week as more investors use the products to navigate the latest disasters in the credit tumult. ETFs on Monday accounted for 40% of all equity transactions in the U.S., on a dollar basis, according to ETF manager Barclays Global Investors. That was up from the 28% daily average as ETFs continue to make their presence felt in markets.
The two most highly traded ETFs, SPDR S&P 500 (SPY, Trade ) and PowerShares QQQ Trust (QQQQ, Trade ), both set daily volume records this week. See ETF Investing blog.
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