Funds that repeatedly perform this financial contortion are likely trying to distract from a serious problem
In the ETF world, an issuer that announces a reverse split — offering an exchange of a fund’s shares outstanding at a ratio generally between 1 for 2 and 1 for 10 — is likely to raise some eyebrows. It’s an uncommon move that, unlike the more common act of a stock split, leaves investors with fewer shares held.
The reverse split is rarely good news for any kind of investment, and it’s even worse for ETFs. “[F] or many ETFs — particularly those that are leveraged, or track volatility or futures, or the inverse of an underlying contract, sector or index — a reverse split is usually a sign of equity being structurally destroyed in a manner that doesn’t happen with stocks,” said Wall Street Journal contributor Nick Ravo in a recent piece.
Issuers would explain such a move by saying that the higher per-share price often means lower brokerage charges for the same dollar-amount transaction. Other reasons are to keep an ETF’s per-share price above minimums required by an exchange, or to reduce the possibility that short sellers could borrow shares in an effort to target the fund.
But Ravo noted that reverse-splitting ETFs are often on the way to a share price of zero, and decreasing the number of shares artificially inflates the price and makes the fund more valuable. “Many ETFs, particularly leveraged ones, have slid toward the delisting death bed in recent years, only to be revived and propped up with repeated reverse splits,” he said.
That means prior to purchasing an ETF, investors ought to watch out for a track record of reverse splits, and be accordingly cautious. As for targeting them for short sales, some financial experts and academics say it’s possible, though they sound some notes of caution.
The long-term chart of an ETF with several reverse splits in its history might make it seem like a natural short-selling target. But many investors lack experience with shorting, and would be exposed to theoretically unlimited losses if they tried. And according to Ravo, many ETFs that do a reverse split don’t have shares available for borrowing; if there were any, the interest charged by the broker who lent the shares are likely to be prohibitively high.
Even if they managed to borrow ETF shares at a reasonable rate, there’s still the risk of a buy-in and closeout — a position being liquidated at the market price, with little to no notice and for any number of reasons, by the broker — possibly leaving the short-seller at an immediate loss depending on the shares’ market price at the time. That’s not to mention the threat of drawdowns (or, in the case of short selling, killer spikes upward) and the higher margin requirements many brokers impose for shorting ETFs.
“Hedging, either with options, diversification, a high cash balance or a partially offsetting position, is strongly advised when shorting ETFs, although the costs will eat into returns,” Ravo said. Some experts may agree, with reservations, that long and short option spreads to either hedge or take outright positions are a feasible alternative for more mathematically inclined investors with shorter time horizons.