ETF industry hits back at Terry Smith

Supporters of ETFs counter Fundsmith founder’s short selling claims.

In his latest note, ETFs – Worse Than I Thought, Fundsmith founder Terry Smith warned ETFs risk being mis-sold, with retail investors potentially mistaking them for index tracker funds. Smith raised a number of concerns about ETFs, including the swap-based funds.

However, he said the more “pernicious danger” with ETFs is the ability to trade them in the secondary market, allowing traders to short the funds. However, investors believe Smith’s short-selling argument is flawed. We offered ETF supporters the chance to respond.

"In an ETF a short seller can always rely on the process of creating shares to ensure he can deliver. This leads to the possibility of buying an ETF share from a short seller when no new share has yet been created."

 

Gary Mairs

Founder and CIO at TCF Fund Managers

“In order for a new ETF share to be created, a basket of stocks has to first of all be delivered to the ETF. An ETF share cannot be created out of nowhere.

“If somebody buys an ETF and they are buying it in the secondary market, obviously someone on the other side is selling it to them. So the seller is either someone who already owns it, or has gone short and is borrowing the share from somewhere, otherwise that trade will immediately fail, because he will not be able to pass the share on to the buyer.

“I cannot see the problem – it is the same as going short in any stock. Every seller will have owned the stock, or borrowed it from someone else, in the normal way. I cannot see the issue.

“His point – which applies to short selling in general – that if there is a lot of short interest in an ETF, and all those investors close their shorts out, that will drive the price up. However this is a general issue with short selling that also affects equities.

Nizam Hamid

Head of ETF strategy for Lyxor AM

“When you borrow shares and sell them in the market place, someone has to buy them. If you turn up on the exchange and buy 500 shares, it does not mean someone goes off and creates 500 shares. For example, if Vodafone trades 50 million shares a day, no new shares have been created – they do not come from the company.

“Short selling, as with equities, is a way of creating market efficiency. We do not believe it is a bad practice; in fact, we think it would help the overall liquidity and tightness of pricing to be able to have an efficient borrow market.

“This is necessary to help people arbitrage what they feel are the price differences and it is this which keeps prices on exchange relatively tight, in the same way you can borrow stock as a market maker and therefore facilitate tight pricing.”

“There is no limit to the short selling that is possible in an ETF, in the same way there is in an equity.”

 

Gary Mairs

Founder and CIO at TCF Fund Managers

“That is not true. Someone has to lend the short seller the stock, so the limit is the fact the lending market will eventually price the cost of borrowing at such a level people will not want to keep increasing the short position. This is the same as any other share.”