For those of a mathematical and mildly masochistic bent, here is more rigorous detail in the form of an induction proof on why there can not be an asset crunch for an ETF so long as naked shorting does not exist. The language in this supplement is more technical and contains hazardous amounts of jargon, because it originated as an e-mail string among our research team. Still, given that this is a weak induction proof, technical language should be the least of any readability issues.
Assume there's a short interest of £a in the fund and a total of £b in other shares out on the market (held by individuals, institutions, etc.--all that matters is that those are shares that are being held and not lent out, making them eligible for sale or redemption).
When an ETF first starts up, £a = £0 in short interest, so there are exactly £b in the fund's trust to match the £b of shares held by long-only investors. Now assume that Hedgie wants to borrow £c in shares and short them. One of the following has to happen:
1) Hedgie sources the shares from one of the existing shareholders
-- Immediately, the number of shares eligible for redemption falls from £b to £b-c, because an institution just lent £c of their holdings and now has collateral to cover their counterparty risk.
-- Hedgie takes the £c in shares and sells them on the open market, increasing the short interest from £a to £a+c.
-- Market participants buy up those £c in shares and consider them unencumbered, increasing the value of shares eligible for redemption from £b-c to £b.
-- Meanwhile, assets in the trust have remained steady at £b this entire time, as there were no creations or redemptions, so there are still assets to match every share eligible for redemption.
2) Hedgie sources the shares from a create-to-lend programme
-- The prime broker and authorised participant creates £c in new shares, increasing the assets in the ETF trust to £b+c, then lends out the £c in shares to Hedgie and takes his collateral.
-- The hedge fund takes the £c in shares and sells them on the open market, increasing the short interest from £a to £a+c.
-- Market participants buy up those £c in shares and consider them unencumbered, increasing the value of shares eligible for redemption from £b to £b+c.
-- Meanwhile, assets in the trust have increased to £b+c due to the create-to-lend process, so there are still assets to match every share eligible for redemption
By this process, the short interest can get as large as possible without ever allowing there to be a big pool of investors holding "phantom shares" that can't be redeemed. The short positions are always fully offset by institutions who know their shares are lent, will not sell without calling the shorts back, and hold collateral to cover the cost of new share creation in case Hedgie goes broke. If all the unencumbered shareholders start selling off, they can make the fund assets fall from £b to zero, but it can't go negative.
A short interest of greater than 100% simply means that £a > £b, but those £a of shorts are still fully offset with collateralised positions of institutional investors.
If you missed the previous article, Your ETF Will Not Collapse, you can find it on Morningstar's ETF Centre or by clicking here.