There are alternatives to selling short in the cash market. An investor seeking to benefit from an anticipated decline in the price of a stock or stock index may be able to do so in the futures or options markets. Shorting individual stocks in the futures market requires the existence of a single-stock futures contract. Where one exists, a study suggests that it is less costly to implement a short selling strategy in the futures market. In the case of stock index futures, it is less costly to execute a short sale in the futures market. Buying puts and selling calls are two ways to implement short selling in the options market. There are trade-offs between buying puts, selling calls, and borrowing the stock in the cash market in order to sell short.
What Are The Most Important Safety Features Protecting ETF Short Sellers?
The trading flexibility and open-endedness of ETFs offer unusual protection to short sellers.
1. It is essentially impossible to suffer a short squeeze in ETF shares. In contrast to most corporate stocks where the shares outstanding are fixed in number over long intervals, shares in an ETF can be greatly increased on any trading day by any Authorized Participant. Creations or redemptions in large ETFs like the S & P 500 SPDRs and the NASDAQ 100 QQQ’s are occasionally worth several billion dollars on a single day. The theoretical maximum size of the typical ETF, given this in-kind creation process, can be measured in hundreds of billions or even trillions of dollars of market value. The open-ended capitalization and required diversification of ETFs takes them out of the extreme risk category. As a practical matter, “cornering” an ETF market is unimaginable. The upside risk in a short sale is still theoretically greater than the downside risk in a long purchase, but even that risk is modified by the way ETF short selling is used to offset other risks.
2. Most ETF short sales are made to reduce, offset, or otherwise manage the risk of a related financial position. The dominant risk management/ risk reduction ETF short sale transaction offsets long market risk with a short or short equivalent position. Unlike the aggressive skier or surfer, the risk manager who sells ETF shares short is nearly always reducing the net risk of an investment position. In contrast to extreme athletes, the risk managers selling ETFs short are more like the ski patrol or lifeguards: They sell ETFs short to reduce total risk in a portfolio.
3. Most serious students of markets consider the uptick rule an anachronism (at best). Requiring upticks for short sales is certainly unnecessary and inappropriate for ETFs that compete in risk management applications with sales of futures, swaps, and options—risk management instruments that have never had uptick rules.
Exchange-traded fund (ETF) short interests have been growing dramatically while the short interest in the typical common stock has declined slightly. We see no particular reason to expect a continuation of the rapid growth in the short interest of many ETFs, but there is also no particular reason to expect ETF short interests to decline, especially for ETF shares used widely in risk management applications. On balance, short selling contributes to the trading efficiency of a few of the more actively traded ETFs. Even more importantly, it contributes to the efficiency of various index arbitrage activities and, consequently, to overall market efficiency.
Investors need not examine or even care about the short interest in an ETF they choose for longer-term investment. The large or small size of its short interest has no implications for a fund’s suitability for long- term investment purposes. Fund analysts and active traders should understand the significance of short selling in the ETF market place, both for its trading cost implications and its sometimes misleading effect on the statistics for share ownership and ETF investment in the aggregate. The ETF short interest is important, but it requires careful interpretation.
Restrictions on Short Selling and Exploitable Opportunities for Investors
Because of restrictions on short selling, many overvalued stocks will be excluded from portfolios by being sold if owned or, otherwise, not bought; however, they will not be sold short. This is because stocks that promise less than a competitive rate of return should be excluded from portfolios but often are not good short sale candidates, especially for those who do not receive use of the proceeds.
It follows that prices are set by the most optimistic investors, not by the typical investor. In many cases the most optimistic investors are also the over optimistic investors. The result is sometimes overpriced stocks that can be identified by good analysis.
Because of the ease of a minority of investors purchasing enough stock to cause it to be overpriced, accounting rules should err on the conservative side. Conservatism will seldom lead to underpricing since there will usually be enough well informed investors to keep the stock priced at least competitively. However, if the accounting sometimes exaggerates profits, there are likely to be enough poorly informed investors for the stock to become overpriced.
The obstacles to short selling, especially failure to receive full use of the proceeds or to receive a market return on them, are more important when the errors in pricing will occur years in the future than when they will be revealed in the near future. Exploitable opportunities to avoid overpriced stocks are most likely when the overpricing is due to various factors that will be typically revealed only years in the future. Possible opportunities arise from things like extrapolating growth too far in the future, not allowing for new entry or market saturation, leaving out numerous low probability adverse events that in the aggregate have an appreciable effect, and the like. Looking for such events several years out probably has a higher return than trying to forecast next year’s earnings, which is where so much effort is expended.
Since competition makes it very difficult to identify stocks that are grossly undervalued, investment success comes from avoiding losers rather than finding great winners. Investing is a loser’s game. If great winners will be very hard to find in a competitive economy, analytic effort should be focused on a small number of stocks which can be extensively studied, rather than on an extensive search for stocks that will double in a year. Typically, investment managers try to follow far too many stocks, frequently failing as a result to uncover relevant negative information about certain stocks.
This yields a theory of bounded efficient markets in which there are upper and lower bounds for stock prices, with most stocks at the lower bound, priced to yield a competitive return. However, the competitive return is higher than the average return. This difference is small enough so that it is probably not worthwhile for individual investors to attempt to pick stocks. However, a small percentage advantage applied to a large sum of money does justify analysis in institutions. It is this analysis that keeps markets close to efficient.
How Short Selling Expands the Investment Opportunity Set and Improves Upon Potential Portfolio Efficiency
Indexing, rather than short selling, is probably the best way for passive investors to optimize their potential portfolio efficiency since, in theory, short selling is not needed to optimize portfolio efficiency as long as market prices reflect equilibrium required returns. But market prices do not always reflect equilibrium required returns. In which case, active investors (who trade based on what they perceive to be some informational advantage) may short sell as a means of improving potential portfolio efficiency. In addition, the rather mixed evidence on whether short selling improves realized portfolio efficiency focuses on risk reduction, so it does not diminish the fact that active investors can improve realized portfolio efficiency, ex post, if they successfully identify and short sell overpriced securities. Of course, this may be more difficult in the future given the growing number of hedge fund managers constructing portfolios with both long and short strategies. Other practical implications follow:
? The risk of recall and the transitory nature of overpricing result in unpredictable durations that require active management of short positions.
? Enhanced indexing with short selling offers active investors the option of focusing on the sell-side of the market. Passive investors may use this strategy to hedge by short selling one or a few stocks, or possibly an index.
? Long-plus-short portfolios allow active investors to manage each side of the market as a separate task. This can be helpful given the unpredictable duration of short positions. Passive investors may use this strategy to hedge their passively constructed long-only portfolio.
? Integrated long-short portfolios are similar to long-plus-short portfolios, except they consider all possible positions together in one integrated optimization. This integrated approach has the potential for improved portfolio efficiency; however, it may be impractical given the unpredictable duration of short positions, especially if the long positions tend to be more passive.
? The magnitude of the short positions in an investor’s portfolio are limited by margin requirements as well as the requirement to escrow short-sale proceeds.
? Adding more leverage to an otherwise fully levered efficient portfolio (i.e., a portfolio in which the margin has been fully utilized given the risky asset allocation) will reduce the proportional amount of short selling allowed, so that the efficiency of the resulting more highly levered portfolio will be reduced.
? Thus, portfolio optimization with realistic asset allocation constraints, that reflect margin requirements and escrowed short-sale proceeds, results in a three-step solution procedure. First, determine the investment weights for long and short positions in the optimal risky portfolio. Second, based an investor’s risk aversion, determine their preferred mean-variance location on the lending-and-borrowing line, along with the associated dollar allocation. Third, determine whether this allocation satisfies the margin requirements. If not, then search for the closest complete portfolio in terms of mean and variance that still satisfies the margin requirements.
? While these short margin requirements apply to individual investors, some long-short hedge funds are effectively able to get around the Federal Reserve Board’s Regulation T short margin requirement of 50% by borrowing additional funds from their brokerage firms.
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