Your ETF Is a Tool. Investors Will Decide How to Use It.

How Investors Use ETFs Isn't Always What Issuers Expect

When an asset manager launches an ETF, there is usually a clear vision of who the intended investor will be and how that investor will use the product.

Perhaps the ETF provides exposure to a particular sector, investment style, or actively managed strategy. The issuer naturally wants investors to recognize its value, purchase shares, and remain invested over time.

But once an ETF begins trading, investors may use it in ways the issuer never anticipated.

Some buy ETFs as long-term allocations. Others use them for temporary exposure, hedging, or relative-value strategies. Some may even short an ETF, not because they expect it to decline, but because it provides exactly the exposure they need on the other side of a trade.

For issuers, understanding these different uses is an important part of understanding their products.

A Short Position Isn't Always a Bearish Bet

Consider an investor who believes growth stocks will outperform value stocks.

Rather than simply purchasing a growth ETF, the investor might buy a growth ETF and short a value ETF.

The investor is expressing a view on relative performance rather than simply betting that value stocks will decline. If growth rises 12% while value rises 5%, the trade can still be profitable, depending on position sizing and costs, even though both ETFs appreciated.

By combining long and short positions, the investor can reduce exposure to broad market movements while maintaining a view on the relative performance of the two strategies. The positions don't have to be equal in size, and the trade still carries market risk, but it allows the investor to focus more directly on the performance difference between the two exposures.

And these strategies aren't limited to passive ETFs.

An actively managed ETF can also become the short side of a trade. An investor might believe another active manager will outperform it, or use the ETF to hedge a portfolio of individual securities.

Shorting an actively managed ETF doesn't necessarily mean the investor believes the manager will lose money. The ETF may simply provide the exposure an investor wants to hedge.

Where Stock Loan Enters the Picture

Whatever the reason for shorting an ETF, the investor needs access to shares to borrow.

Hedge funds typically work through prime brokers, whose stock-loan desks source shares for short selling.

If sufficient shares aren't available, a stock-loan desk may arrange to have additional ETF shares created specifically for lending. This is commonly known as create-to-lend.

Whether the transaction makes economic sense depends on the borrowing rate, expected loan duration, creation costs, financing, and other considerations.

Not every short position leads to a creation. But when the economics work, stock-loan demand can produce substantial ETF creations, even though the ultimate investor is short the fund rather than long it.

I learned an important lesson about this earlier in my ETF career.

A Lesson From a Semiconductor ETF

Years ago, while working for an ETF issuer, I watched one of our semiconductor ETFs experience a substantial increase in shares outstanding.

The creations were meaningful, and naturally, I was pleased to see the additional assets coming into the fund.

A few months later, much of that increase reversed as shares were redeemed.

I remember being disappointed. We had attracted significant assets, only to see them leave relatively quickly.

My boss at the time, who was also a mentor to me, explained what had happened.

A hedge fund had been using the ETF as part of a long/short strategy within the semiconductor industry. It wanted to own certain semiconductor companies while using our ETF to hedge broader industry exposure.

The short position generated demand in the stock-loan market, and additional ETF shares had been created to facilitate lending to the hedge fund.

When the hedge fund unwound its trade, the borrow was returned, the additional shares were no longer needed, and the associated ETF inventory was redeemed.

My mentor explained that I was looking at the situation the wrong way.

Our ETF had done exactly what it was supposed to do.

The hedge fund had a dependable instrument for its strategy. The creation and redemption mechanism worked. Existing shareholders were not adversely affected by the activity, and the issuer earned its management fee while the additional assets were outstanding.

Everyone involved had accomplished what they wanted.

And, as he pointed out, hopefully the hedge fund would come back and use the ETF again.

Of course, every issuer would prefer assets that come in and stay. Stable, growing assets help build a sustainable ETF business.

That experience changed how I thought about ETF flows. What initially looked like a lost asset-gathering opportunity was actually an example of the ETF functioning as a useful market instrument.

What ETF Issuers Should Take Away

ETF issuers understandably focus on attracting investors and building long-term assets. But not every meaningful use of an ETF results in assets that remain in the fund indefinitely.

A large creation followed by a redemption doesn't necessarily mean the ETF disappointed investors. And short interest doesn't necessarily mean investors have a negative view of the fund or its strategy.

Sometimes those activities simply reflect an ETF doing exactly what it was designed to do: providing reliable, tradable exposure.

That lesson from my mentor has stayed with me throughout my career.

An ETF is both an investment product and a market instrument. The issuer builds it, but ultimately the market decides how to use it.

Disclaimer

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.