Why Two Financial Short ETFs Stopped Trading
Monday September 22, 11:29 am ET
By Simon Maierhofer
In its infinite rule-making wisdom, the SEC has added yet another caveat to the already unsettled financial world. Banning the short sale on 799 financial securities has caused 'liquidity' problems for a set of ProShares Financial ETFs.
Following the announcement of the ban on short sales the ProShares UltraShort Financials (AMEX: SKF - News) and the ProShares Short Financials (AMEX: SEF - News) stopped trading for a good portion of Friday morning. This break was sorely needed to give ProShares a chance to sort through the implications of the ban.
What caused the halt in trading?
Financial short ETFs were affected even though short ETFs don't actually short the underlying securities. Swaps and futures are typically used to produce inverse returns. Swaps are custom contracts between institutions. In return for a fee from ProShares, the counterparty agrees to pay the return (or inverse return) on an agreed-upon index.
How does the counterparty hedge their position? Through short sales. Can you see how the restriction of short sales would reduce the amount of counterparties willing to take a risk without hedge? To further complicate the matter, it should be mentioned that counterparties include companies such as Merrill Lynch, Morgan Stanley, Goldman Sachs (and at one time Lehman Brothers), all of which are pre-occupied with simply staying alive.
There appears to be an exemption for ETF and ETN market makers to short financial stocks. ProShares does not short equities (at least so far) and it is unclear whether this exemption extends to counterparties. Needless to say, Morgan, Merrill, Goldman and co. do not want to further agitate the SEC and prefer to be on the safe side.
How does this affect the price of SKF and SEF?
The existing ETFs will continue to trade. Redemption of ETFs is not an issue, there won't however be any new units created. Scarcity of a product drives up the price, therefore it is expected that SKF and SEF will trade at a premium.
When will the ban on short-selling end?
The ban will be in force until October 2, 2009. It wouldn't be out of line to assume that the ban will be extended if financials continue to slide.
What other options are there?
The Rydex Inverse 2x S&P Select Sector Financial ETF (AMEX: RFN - News) is very similar to the ProShares double-short ETF. RFN is based on the S& financial sector while SRF is based on the Dow Jones financial sector. Rydex and ProShares are in the same boat, so switching from one to the other would be like jumping from the frying pan into the fryer.
The ban only covers individual financial stocks, so you are allowed to short financial ETFs. The main financial ETFs are: Financial Select Sector SPDR Fund (AMEX: XLF - News), iShares Dow Jones U. S. Financial Sector Index Fund (AMEX: IYF - News), iShares Dow Jones U. S. Financial Services Index Fund (AMEX: IYG - News), Vanguard Financials ETF (AMEX: VFH - News) , PowerShares Dynamic Financials Sector Portfolio (AMEX: PFI - News), PowerShares FTSE RAFI Financials Sector Portfolio (Nasdaq: PRFF - News), First Trust Financials AlpahDEX Fund (AMEX: FXO - News), Rydex S&P Equal Weight Financial ETF (AMEX: RYF - News).
Another option is to buy put options on either individual financial stocks or on the following ETFs (not all ETFs offer options): Financial Select Sector SPDR Fund (AMEX: XLF - News), iShares Dow Jones U. S. Financial Sector Index Fund (AMEX: IYF - News), Vanguard Financials ETF (AMEX: VFH - News).
Please be aware that shorting ETFs and/or purchasing options accentuates the performance results due to the leverage nature of both alternatives.
Will other short ETFs be affected?
The ban is limited to financial stocks and effects have thus far been limited to short financial ETFs. Rydex and ProShares offer a full line of short and leveraged short ETFs most of which have no or limited exposure to the financial sector. Broader short ETFs such as the Rydex Inverse 2x Russell 2000 (AMEX: RRZ - News) or ProShares UltraShort S&P 500 (AMEX: SDS - News) might see similar problems if confronted with a sudden influx of new money necessitating a large amount of new swap agreements.
Any problems would be on a smaller scale as the exposure of broad indexes (Dow Jones, S&P 500, Russell 1000, 2000 or 3000) to financials is limited to between 10 and 20%.
As the Fed, SEC, government and Treasury Secretary are making decisions on bailouts, rule-changes and new entities more or less on the fly, it will be interesting to see what other unwanted 'side-effects' investors (and tax payers) will have to deal with.
Once again, the regulatory body is left only to re-act rather than act, following a trend rather than setting a trend. Certain things just don't change.
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