Can a Short Squeeze Collapse an ETF?

Some people have been hyperventilating about the high short interest many ETFs are showing.   XRT for example recently had 95 million shares in short interest with only 17 million shares in shares outstanding.    If you want a detailed response to these fearmongers I found this article to be very helpful.

If all of the people that were short XRT decided that they wanted to cover their position simultaneously that would create an interesting situation.   The cool thing about ETFs is that if the value of XRT started to significantly diverge from the value of the S&P retail stocks that compose the index (the net asset value or NAV)  then arbitrageurs would step in to provide liquidity.

In a short squeeze on XRT, where there aren’t a lot of shares around for sale, its value would start rising above its NAV.  Once that gap becomes significant arbitragers would start buying the basket of stocks represented by the XRT and creating XRT shares to sell priced at a premium–for a guaranteed profit.  This share creating process is spelled out in the XRT prospectus of the ETF in the “Purchase and Sales Information” section.

There is a lot of capital available when guaranteed profits are up for grabs.

Because in this case XRT’s price goes up the shorts get hurt, but no one ever feels sorry for the short sellers.  A short squeeze on an ETF, rather than being a cause for concern, should result in a nice little bump in its volume and value.