“Exchange-Traded Funds, or ETFs, are a cheap, handy way to bet that a broad swath of stocks or bonds will rise. But scads of short-sellers are using them to bet on a plunge,” writes Ian McDonald in today’s Wall Street Journal.

“These portfolios are index-tracking stock or bond mutual funds with a twist. Unlike traditional open-end mutual funds, ETFs trade on exchanges, pricing throughout the trading day like a stock. They’re often pitched to ‘buy and hold’ individual investors because they offer diversification, low expenses and tax efficiency.”

“These same attributes make them appealing to another constituency some call the ‘glass is half empty crowd’: short-sellers, who aim to profit from a security’s tumble. So-called shorts borrow shares and sell them, hoping to return them at a lower price later and pocket the difference.”

“On May 14, the latest date for which statistics are available, short sales were equal to nearly half of the $22.4 billion Nasdaq-100 Index Tracking Stock’s outstanding shares and nearly a quarter of the outstanding shares of the $40.2 billion Standard & Poor’s Depositary Receipts, which follows the S&P 500-stock index.”

“In fact, the 10 largest ETFs by assets averaged 21% short interest, according to figures gathered by ETF Consultants LLC in Summit, N.J. By comparison, the average stock’s short interest — or shares shorted as a percentage of outstanding shares — is usually between 1% and 2%.”

“Who’s doing all this shorting? Institutional investors, including hedge funds, are the primary players in the shorting of ETF shares. While exact figures are hard to come by, ETF firms say they believe about 60% of their shares are held and traded by institutions, with the rest held in individuals’ accounts.”

” ‘The short side is mostly institutional,’ says Deborah Fuhr, a London-based ETF analyst for Morgan Stanley. Ms. Fuhr has surveyed institutional ETF holdings each June for the past three years. In 2000, 448 institutions held ETF shares globally, but that number rose to more than 1,335 last year, she says. It’s not easy to tell what strategies hedge funds employ, because they don’t have to disclose their portfolio positions. But the same doesn’t go for mutual funds using ETFs. One example: Fund manager Bill Miller had nearly 17% of the $3 billion Legg Mason Opportunity Trust Fund invested in a short of the Nasdaq-100 Index Tracking Stock at the end of the first quarter. Mr. Miller wasn’t available to comment, but in last year’s annual report to shareholders, he noted that the ETF position was intended as a hedge against potential losses.”