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Msg  12821 of 12945  at  1/17/2020 5:14:03 PM  by


Weird indexing

[source: Bloomberg Opinion - Money Stuff]

We talked yesterday about an unusual exchange-traded fund called SDY, the SPDR S&P Dividend ETF. This is a passive ETF that owns large-cap stocks with high dividend yields; it chooses stocks from a large-cap index, and weights those stocks by dividend yield. This has a weird effect: As a stock’s price goes down, its dividend yield, arithmetically, goes up, since the dividend yield is just the dividend divided by the price. So SDY buys more of a stock as it goes down. But if a stock goes down too far, its market capitalization will be too small for the large-cap index, and it will be booted from the index, which means that SDY will have to sell its entire position.[1] Which got bigger on the way down. This is apparently about to happen to SDY with two stocks—Tanger Factory Outlet Centers Inc. and Meredith Corp.—and it is awkward. SDY has built up big stakes in those companies, about 22% and 18% of the shares outstanding, respectively, and now it will have to dump them all at once. 

You would expect this huge forced selling to be bad for the stocks’ prices, and for SDY’s performance. But there is a silver lining. There is a lot of short interest in Tanger stock: A lot of people were betting against it, by borrowing stock and selling it short. Often these people were borrowing the stock from index funds: Index funds tend to be enthusiastic stock lenders, because they are stable owners of big blocks of stock and can boost returns slightly for their investors by lending the stock out to short sellers and charging a fee. This means that large index ownership of a company can cause increased short selling of that company: If there are lots of shares available to borrow cheaply, then more investors might be tempted to bet against the company by selling short. “Short interest in SKT [Tanger’s ticker symbol] has been exacerbated by the stock’s above-average ownership among passive holders, who are among the largest lenders of shares at relatively lower costs to the borrowers,” research analysts at Citi wrote in a note to clients last week.

And now if SDY has to dump Tanger—the date for this sale seems to be the end of this month—then that will be tough on those short sellers. From a Bloomberg Intelligence note this week:

SDY's situation could get stickier because a record 57% of Tanger's shares are shorted. SDY's issuer, State Street, is likely the lender of some of those shares and will presumably have to call them back for the reconstitution. This may have been unexpected, given that Tanger's market cap exceeded the $1.5 billion threshold for most of 2019. 

The stock was up 10% on heavy volume last Wednesday, possibly for that reason. Citi wrote at the time:

Those shares would have to be called in prior to the 1/31 effective date, as State Street can’t settle the sold shares if they are lent out. From what we understand, the buy-in would likely occur after the 1/24 announcement date but before the 1/31 effective date, which could result in a short squeeze during that time. But we’ve also learned that State Street has issued a presale notice in recent days, likely causing the domino effect we’re seeing in the market today, whereby the borrow cost is rising in anticipation of what is to come.

SDY’s large concentrated ownership of Tanger allowed a lot of people to be short the stock. As the stock went down, SDY had to increase its ownership, and the short selling seemed like a better and better idea. But now SDY has to get out of its ownership, which will make it harder for people to be short the stock. So the short sellers will have to buy a lot of stock, at the same time (well, almost the same time—slightly earlier, really) that SDY has to sell a lot of the stock. Obviously they should just trade with each other, but never mind that, the more general point is that the system is, goofily, self-regulating. SDY bought too much stock and then had to get out of it suddenly, but also short sellers sold too much stock and have to buy it back suddenly, so it all, sort of, works out fine.

By the way, a fun model of passive investors and short sellers would be something like “all index funds lend out all of their shares to short sellers, all the time, and all shares sold short are borrowed from index funds.” This is not, of course, true: Not all index investors lend out their shares, plenty of non-index investors lend out their shares, and anyway most companies don’t have all that much short interest, so even if index funds were willing to lend out all of their shares they probably wouldn’t be able to. But it is, you know, vaguely in the direction of true; more index funds lend out more of their shares, etc., and if you are shorting a stock there is at least a decent chance you’re borrowing that stock from an index fund. “All index-fund-held shares are sold short and all short shares are borrowed from index funds” is not accurate, but it is a nice thought experiment, an extreme and sharpened form of some trends that are true.[2]

What would be the implications if it was true? We talked about one last month. People worry sometimes about the concentrated voting power that index funds have over public companies; when a company’s largest shareholders are big index-fund firms, what does that mean for corporate stewardship and competition and so forth? But in my thought experiment these issues are just fake: Index funds own a lot of shares, but they don’t get to vote them, because they lend them all out to short sellers and the votes travel with the shares. (Index funds own shares, which they lend to short sellers, which the short sellers sell to active non-lending long investors, who get to vote.) Again this is not quite true, but it is not entirely untrue either, and the voting power of index funds—and its implications for corporate governance and the environment and the world generally—is probably overstated because people forget that index funds lend out a lot of their shares.

But you could extend that logic. People worry about the impact of index funds on price discovery: If index funds have to just buy all the stocks, aren’t they contributing to bubbles or erasing the price difference between good and bad companies or affecting volatility or otherwise undermining market efficiency? But in my thought experiment the answer is no: The same amount of price discovery goes on, because the index funds lend their shares to short sellers who have active (negative) views on the stock, and who sell those shares to long investors who have active (positive) views. The market balances the views of active long and short investors. The index funds do not, as it were, take any shares out of circulation.[3] They are essentially pass-through entities; they have economic exposure to companies but only momentary ghostly possession of their shares

In its extreme form you can think of this thought experiment as suggesting that index funds don’t really exist, that they are an illusion, that their passivity is so complete that they vanish, that they provide a way for people to bet on the stock market without participating in the stock market: Active long investors buy, and active short sellers short, and index funds passively stand in between them, mirroring their activity without affecting it.


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