By Danielle Rutsky, Analyst for the DWS ETF Capital Markets team.
Danielle Rutsky, Analyst for the DWS ETF Capital Markets team.
In November 2018, the market saw a phenomenon in high yield ETFs where performance was dropping off but shares outstanding was increasing.
Millions of dollars flew into fixed income ETFs tracking the high yield bond market in November while these products were experiencing their worst decline since 2015. What is the explanation for this paradox?
We suspect it could have been either strategic investors buying the dip or short-seller demand being so great for the asset, that stock loan desks created shares to lend out. The latter is a trend that has happened multiple times throughout ETF history.
A quick detour to explain, “buying the dip” is when an investor buys a security with strong fundamentals that has experienced a sell-off. They believe the security has growth potential and the drop in price simply has created a buying opportunity.
On the other hand, short interest is a measure of short-seller demand and is driven by investors who believe the security’s price will fall further due to expected lower earnings or other negative indicators. In this case, the investor borrows the security from a market participant who owns it and sells the security to someone else. The investor, or short-seller, then hopes the price declines so they can buy back the security at a lower price and return it to the market participant who originally owned it.
The breakdown
As mentioned, there are multiple scenarios that can account for inflows during periods of performance weakening such as investors buying the ETF at a level they believe has good value, investors buying the ETF to hedge a certain exposure, and investors triggering creates as they lend out the ETF.
The last scenario normally occurs in hard-to-access markets as investors may not have other liquid vehicles to execute their view and can be identified by further analyzing the short interest. When short interest for an ETF is rising in conjunction with rising shares outstanding, but lower prices, we can assume a ‘create to lend’ situation is occurring. This is when the demand to borrow the ETF elevates to the point where the stock loan desk could create shares to lend out at a higher rate.
A similar pattern can be observed in 2014 following Russia’s intervention in Ukraine with a major ETF tracking Russia. The share price steadily dropped almost 50% from July 2014 to January 2015, while shares outstanding jumped 61%.
Russia ETF falls in price as its shares outstanding rises:
Source: DWS.
The indicator that connects this period for the Russia ETF to a ‘create to lend’ situation is the nearly 200% spike in short interest. The short story is: the demand to short Russia was so incredible, the fee to borrow practically doubled and stock loan desks could collect a premium from creating shares to lend to the end borrower.
The Russia ETF’s borrow rate and short interest amount simultaneously rise:
Source: DWS.
Energy ETF examples
To add support to this theory, one of the largest natural gas ETFs has exhibited signs investors may use the product as a way to short the natural gas market. The ETF tracking natural gas saw sustained declines from December 2014 to March 2016 and from October 2016 to November 2017 when prices dropped 72% and 24% while shares outstanding jumped 138% and 280% for those periods, respectively.
Who would create shares of a natural gas ETF when the outlook for gas was so cloudy? The answer is found in the corresponding short interest spikes for the time series of 230% and 330%. This would suggest investors are shorting the ETF to the point stock loan desks are creating shares to lend out.
Another classic example of an energy ETF being used as a vehicle to short the market can be seen with a major crude oil ETF from July 2014 to January 2015. Shares outstanding climbed 284% as an unanticipated increase in oil supply flooded the market and caused prices to drop about 50%. Explaining the inflow was an 86% jump in short interest which suggests it was another ‘create to lend’ situation.
The other possibility
On the other hand, we also observed an instance of investors going long and driving share creations during a period of weak performance with respect to China. Following the US administration’s first announced tariff on China, a mainland China ETF fell in price by 30% from February 2018 to November 2018. Shares outstanding increased by more than 130% for the China ETF over that same time period.
When trade war headlines picked up in April, demand to borrow the ETF pushed rebates to their highest point in 2018 of almost 7%. Proving investors began buying while Chinese equity prices were depressed, the rebate for the ETF was much less volatile and low during the fourth quarter of 2018, hovering around 1%. This indicates as tariff headlines quieted, there was lower demand to borrow the ETF tracking China due to fewer short-sellers. The deterioration of trade talks during those months created an opportunity for investors interested in China to buy the dip.
The fixed income phenomenon
Multiple factors may also combine to push short-seller demand higher. As prices declined for high yield ETFs the week of 12 November 2018, shares outstanding for one of the largest high yield ETFs increased 8%, signifying fund inflows. Interestingly, short interest bumped up for this ETF in conjunction with decreasing shares outstanding, signifying outflows for a competitor ETF. At a time when spreads were widening and were expected to continue widening, the short interest and competitor outflows suggest the flows into the high yield ETF were not investors buying the dip.
The third week of November was also when options contracts expired which means as investors put new high yield option positions on, market participants looking to hedge bullish exposure would need to short high yield products. The cost to borrow for the high yield ETF correspondingly saw an uptick of almost 40% during the week which supports that options expiring and investor speculation combined to create a large spike in short-seller demand. This borrowing triggered the ‘create to lend’ scenario, and hence ETF inflows, once again.
(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)