The U.K.’s surprising vote to exit the European Union has many investors reassessing their portfolios, rethinking allocation decisions surrounding Europe. One of the things some may be considering is shorting ETF positions.
There are two main reasons someone might want to short an ETF. To quote Fidelity research, short sales happen either as a hedge to a long “related” position, when investors want to offset some of the risk associated with that position, or because the investor expects the price of that ETF to drop in the near future.
How To Short An ETF
Short-selling isn’t all that common among long-term investors, and the process to short-sell isn’t difficult, but it’s “labor-intensive,” as Fidelity put it.
The fact is that if you want to short, say, a European equity ETF because you believe it will decline in price following the ‘Brexit,’ you would first need to borrow shares of that ETF. That process, known as securities lending, is a widely used practice that contributes to “tighter index tracking and better overall returns,” according to ETF.com research. But it involves some work.
As the investor, you can borrow ETF shares from the issuer, and market makers can make as many shares of an ETF for short-selling as there’s demand for it. You would also have to post collateral to the securities lender and fees—rates that vary depending on the ETF, on how liquid it is, on the lender, etc.
Under the lending agreement, the short-seller would be required then to repurchase these shares at a later date, and replace them with the original owner.
Great Idea With Great Risks
The central idea of short-selling is to sell high, buy low. But there are many risks associated with short-selling. The primary one is financial loss.
“The central danger of short selling is that a trader or investor’s potential loss, or downside, is unlimited because share prices can rise infinitely,” Fidelity research said. “With a long position, the investor is risking only the amount that he or she spends. In a short sale, losses can accumulate far beyond an investor’s original expectations.”
Despite the risks, an event like Brexit could spark some short-selling activity. Perhaps the cleanest short play in the face of Brexit would be a currency-focused one: shorting the CurrencyShares British Pound Sterling Trust (FXB | B-99).
Following the vote, the British pound declined to a 30-year low, while the U.S. dollar rallied to a three-month high. If these trends hold in place—as many say they should—shorting FXB just might work as the pound declines in value.
FXB exposes investors to changes in the value of the British pound relative to the U.S. dollar through a portfolio that holds physical British pounds in a deposit account.
The fund is very liquid, trading an average of $11 million a day at pretty tight spreads of 0.03%, according to FactSet data. That liquidity makes FXB a prime choice for investors looking to tap into the pound, short or long.
Another interesting currency plan could be to go long the PowerShares DB US Dollar Index Bullish Fund (UUP | B-73). UUP is a bullish bet on the dollar, but one that is built around an inverse exposure. The fund is linked to an index of dollar futures that rises in value as the dollar appreciates relative to a basket of world currencies.
UUP essentially is long the U.S. dollar and short the euro, the Japanese yen, the British pound, the Canadian dollar, the Swedish krona and the Swiss franc. Weakness in any of these currencies relative to the dollar is a boon to UUP.
Consider the performance of FXB and UUP in the last month:
Playing The Inverse Angle
Another way for bearish investors to play Brexit through the currency view is to look into inverse ETFs tapping into the euro. No shorting an ETF is necessary, because these funds are inverse plays. For example, the Market Vectors Double Short Euro ETN (DRR) provides two times the inverse exposure to the euro relative to the U.S. dollar. In theory, for every 1% down move in the euro relative to the dollar, DRR ideally should move up 2%, according to FactSet data.
As is the case with any leveraged strategy, daily rebalancing makes long-term returns difficult to predict, but if you are bearish the euro, this inverse play on the euro may be your cup of tea.
A similar strategy—and 10 times as big, with $367 million in assets—is the ProShares UltraShort Euro (EUO). The fund also offers 2 times the inverse exposure to the dollar/euro cross.
In the past month, both DRR and EUO have seen gains:
Shorting European Equity
In the equity space, investors could easily short Europe-related equity ETFs depending on their view.
The iShares MSCI United Kingdom ETF (EWU | B-90) is the biggest pure-play exposure to U.K. equities in the market today, with $2.1 billion in assets. The fund covers the top 85% of British companies by market cap, and holds financials as its biggest sector allocation, at about 21% of the portfolio.
The financial sector could be in a prime spot to first feel the impact of any loss of EU subsidies or access to credit associated with Brexit.
If that’s the case, other financial-sector-focused ETFs could find short-selling demand as well. For example, the iShares MSCI Europe Financials ETF (EUFN | B-89) invests in financial stocks across developed Europe. Here, the U.K. is the fund’s largest country allocation, at more than 30% of the overall portfolio, and banking services represent over 50% of the mix.
The broader-in-scope SPDR S&P International Financial Sector ETF (IPF | D-90) owns financial companies outside the U.S., including Japan and Australia. The U.K. is the portfolio’s second-largest country allocation, at about 14%.
These ETFs have all faced losses in recent weeks, as the one-month chart below shows:
Charts courtesy of StockCharts.com
Be it through currency, inverse or equity ETFs, these are just some examples of the Europe-related ETFs that investors could short-sell if Brexit has them looking for lower prices or risk-hedging opportunities. For a comprehensive list of ETFs tapping into this universe, check out our ETF screener and database.
Contact Cinthia Murphy at email@example.com.
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