Morningstar.com
Short-Sale Restrictions and Inverse ETFs
Friday September 19, 7:00 pm ET
By John Gabriel
There's a palpable sense of fear and uncertainty in the markets today. This helped lead to a number of unprecedented government actions this week including a wide sweeping ban on short sales of 799 financial stocks, tapping into a $50 billion fund to guarantee money market assets, and discussions of creating a Resolution Trust-like vehicle to help shore up the balance sheets of struggling financial institutions.
Following the announcement of the ban on short sales, two ProShares inverse funds (including the widely held UltraShort Financials ProShares (NasdaqGS:SKF - News)) ceased trading for a couple hours this morning in order to give the issuer a chance to sort through the implications of these government actions. In this article, we will attempt to shed some light on the situation by addressing the major questions about what happened this morning and how the Securities and Exchange Commission's restriction on short selling financial stocks will affect exchange-traded funds in the future.
If these funds use swaps agreements to replicate inverse returns on their stated benchmarks, then why are short-selling restrictions on individual financial stocks affecting and Short Financials ProShares (AMEX:SEF - News)?
It's true that these ETFs don't actually engage in short selling to produce inverse returns on their stated benchmarks--they typically use swaps and futures, which are contracts to pay a fixed amount of interest in return for a counterparty paying the return on an agreed-upon index (in this case, the Dow Jones U.S. Financials). However, issuers like ProShares cannot find willing counterparties to the swaps they would need to write, as the counterparty would need to hedge the position by shorting financials. With the short-selling restriction in place, there aren't any counterparties willing to assume this huge risk. Keep in mind that most often the counterparties we are referring to are investment banks, such as Goldman Sachs (NYSE:GS - News), Morgan Stanley (NYSE:MS - News), and Merrill Lynch (NYSE:MER - News)--each of which are dealing with their own issues amid the credit crises.
Ostensibly there's an exemption for the ETF/ETN market makers that create and redeem shares to short shares as part of an ETF portfolio hedge, but ProShares does not short equities in any of its portfolios nor does its prospectus explicitly reserve the right to short equities. The language of the emergency order also makes it difficult to tell if a broker-dealer would be allowed to short financial stocks in order to hedge an ETF's swap position. At this stage in the game, with the capital constraints and confidence issues that these firms are currently facing, banks taking the other side of ProShares' swaps may just not want to risk incurring the SEC's wrath.
The bottom line is this: The lack of counterparties means that new swap agreements are extremely difficult to obtain, so no new assets can be invested and no more shares created (see ProShares' press release).
Why did SKF and SEF stop trading?
As previously discussed, due to the short-selling ban on financial stocks, there are no counterparties willing to buy/write the issuers' swap agreements, as the wide sweeping ban on shorting financial stocks means that the counterparty would be unable to hedge away its exposure. The shares of these ProShares ETFs did resume trading in the financial markets today, but they seem to be trading at prices that are not in line with their intraday indicative values. This is to be expected, however, based on the simple laws of supply and demand. Viewed as one of the remaining avenues to gain short exposure to the financial sector, the demand for the SKF and SEF were expected to explode. Essentially, all who were covering their existing short positions in response to the ban were expected to attempt to gain short exposure via these inverse financial sector ETFs.
Thus, ProShares contacted the American Stock Exchange this morning to note that it was not planning to create new shares in light of the SEC's unprecedented ban on shorting 799 financial stocks. The AMEX responded by halting trading on the securities to prevent huge diversions between the indicative benchmark value and market price.
What are the likely effects of this until the end of the short-selling ban on Oct. 2?
As long as investment banks are concerned about capital reserves and the amount of risk on their books, they are unlikely to write swaps that short financials. Thus, existing shares of these inverse financial ETFs should continue trading, but new shares will not be created.
According to its prospectus, ProShares invests in only derivatives (including options, swaps, and forwards), so it does not actually short the stocks itself. An emergency amendment to the prospectus that would allow the issuers to engage in short selling is a possibility, but unlikely in our view.
So long as ProShares is unable to find counterparties to short the index, it will continue to allow only redemptions and not creation of new shares. This will prevent the ETFs from trading at a discount, but it will allow them to trade at a substantial premium (as no authorized participants can arbitrage the premium away by creating new shares and selling them until the premium disappears). We've already noticed the SKF trade at a 5%-6% premium over net asset value.
Even if investment banks stabilize and become willing to take risk onto their balance sheets before Oct. 2, the expenses on these funds will increase substantially as counterparties demand much higher interest payments to take on the unhedgeable risk. This cost would be expressed in the fund's expense ratio.
In our opinion, the only hope of clearing this up before Oct. 2 is either an SEC clarification that broker/dealers can short stocks to hedge derivatives bought by ETF market makers, or a change to the ETF prospectuses that allows the funds themselves to short stocks directly.
What else can I do in the meantime?
Although investors cannot currently short sell individual financial stocks, there is no ban on shorting ETFs that court exposure to the sector, such as the Financial Select Sector SPDR (AMEX:XLF - News) (long financials) or the Ultra Financials ProShares (AMEX:UYG - News) (double-long financials). Individuals could short UYG instead of buying SKF, although we'd note that this leaves open the potential for bigger losses over multiday periods due to the compounding of leveraged daily returns. The Rydex Inverse 2x S&P Select Sector Financial (AMEX:RFN - News) is still trading and creating new shares, although it is also likely to have trouble finding willing counterparties if it faces a wave of new assets flooding in to short financials.
Investors who already own SKF or SEF can sell the funds at any time because trading has recommenced, and since redemptions are still allowed, there is little risk of selling at a discount. In fact, there may be a good chance of selling at a significant premium sometime before this situation resolves itself.
Will any other short ETFs be affected?
There is a chance that other short ETFs such as UltraShort S&P 500 ProShares (AMEX:SDS - News) may have similar trouble if they face a sudden influx of assets necessitating a large number of new swap agreements. However, these funds are not as large as UltraShort Financials (in terms of assets under management), and their underlying indexes have only a 15%-20% stake in the financial shares that cannot be shorted. Thus the risk to a counterparty from entering into those swaps with ProShares is much smaller than on the financial indexes, so broker/dealers are much more likely to continue entering swap agreements on the broad market indexes. The market for these broad index swaps is also much more liquid, so ProShares would be able to find more potential counterparties than with the financial sector index swaps, where the firm represents a much larger portion of the market. |
