The ETF is absolutely the greatest instrument ever invented for the purpose of selling short.
First of all, ETFs, like most investment pools, charge an annual management fee – typically disclosed as the “Management Expense Ratio”. As we all know, the fee is expensed out of the fund, which means that if all else stays the same, the value of the fund will slowly decay by the MER every year automatically. The flip side is that this is an inherent bias favoring the short side. If you are short an ETF, you are essentially getting paid an annual fee for doing nothing.
Let’s look at a simple example. Let’s say you are bearish on the Eurozone and would like to bet against the Euro spot rate. Why go through the trouble of opening an FX account and sell Euro there, when you can instead short the Euro currency ETF (FXE), where you will get paid the fund’s MER of 0.40% on top of speculating on Euro’s demise? Perhaps by habit. But as long as FXE is not trading at a significant discount to NAV, there is no reason why one would choose to short the underlying rather than the fund.
These single asset ETFs are godsend. Yes, regular mutual funds charge management fees as well, but none have the ease of shorting like ETF. The same situation applies for any single currency ETFs, as well as precious metal ETFs and commodity ETFs. Oh – did I mention those crazy commodity ETFs?
That brings us to the second reason why exchange traded funds provide such great shorting opportunities. By now it is clear that contango – a phenomenon where contracts for delivery of commodities far in the future are priced higher than contracts for delivery in the near future – is the bane of futures-based commodity ETFs.
A prime example is The US Oil Fund (USO), where the objective is to track the WTI oil price by holding future contracts of the nearest delivery. Of course, the fund doesn’t actually have the means and storage space to take delivery on several million barrels of real oil. So as the contracts approach delivery date, the fund is forced to roll them to the next delivery date by selling the existing contracts and buying the following month’s contracts, thus paying the difference caused by contago (AKA “roll yield”).
Other futures traders know this, and they are able to profit from front-running USO by buying next month’s contracts ahead of the fund, thus exacerbating the fund’s cost of rolling the contracts. At inception, USO started out with near 1:1 ratio to the price of oil, but after years of underperformance, it is now trading at around $38, a staggering 57% discount to the actual oil price.
Now I am by no means advocating shorting oil at this point in time or ever in the future. But if your own macroeconomic view and investment strategy dictate that you should short it, why on earth would you not select USO as the vehicle for implementing your strategy?
This article is not an exhausive list of the short-comings of ETFs. There are other good examples, like those leveraged short Treasury funds such as ProShares UltraShort 20+ Year Treasury (TBT). It may sound counter-intuitive, but after all that MER, margin costs and other risks of leverage, I would not be surprised if shorting the short Treasury fund performs better than simply going long on real Treasuries! A poorly structured fund works to the advantage of the short-seller – being traded on an exchange just makes the short position simpler to implement.
Don’t get me wrong – I am not against all ETFs, because some do add value for investors and have a place in the investment universe. For example, emerging and frontier market funds provide access to markets that would otherwise be difficult for the public. An actively managed ETF provide a cheap way to access the skills of a particular fund manager. Even funds that simply replicate an index save investors time and effort from assembling the components themselves. All these types of funds add value that justifies the MER.
But single asset ETFs, like the one on the Canadian dollar (FXC)? Not so much.
Boy I can’t wait until these jokers start offering single stock ETFs. Or better yet, an ETF on a single-stock-future!