Shorts piled into stock ETFs reach fever pitch

The love affair between short sellers and exchange-traded funds reached a fever pitch as equities tumbled in October.

As markets went south, investors ran for exchange-traded funds to hedge, according to financial technology and analytics firm S3 Partners. Total short interest in ETFs rose more than 7% to $176.5 billion of shares. Much of the pessimistic bets were placed on funds tracking common indexes, including SPY, which tracks the S&P 500, and QQQ, on the Nasdaq 100 ETF.

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Given the heavy use, a natural conclusion is that the rally of the last three days — the biggest in 16 months for the Nasdaq 100 — is being propelled by traders buying back ETFs and stocks they borrowed and sold. The Nasdaq 100 has gained more than 5% in the last three sessions, though an ETF tracking it slipped after Thursday’s close.

“In October, short sellers were looking for more short exposure in the more crowded equities (both retail and indexed),” said Ihor Dusaniwsky, managing director of predictive analytics at the firm. “If the market stabilizes and continues its rally, there may be $21 billion of October short sales ready to be covered and boost the rally even further.”

To Matt Maley, equity strategist at Miller Tabak & Co, the gains in equities are clearly attributable to short covering. The S&P 500 gained 1.1% Wednesday while the Nasdaq 100 rose 1.5%, both extending their three-day streaks to the best since 2016.

“When we see sell-offs and bounces back, everyone asks 'is this buying the real thing or a short covering?’ It’s always a short covering at the beginning,” Mr. Maley said. “The reason why it’s always a short-covering rally at the beginning is that they’re more willing to buy stocks that are down because they’re not taking a chance of losing money. They’re just taking profits.”

(More:​ ETF buyers seek defensive plays amid market turmoil)

Not everyone thinks ETF covering alone would lift the market. Buying and selling spurred by the creation and redemption process underlying the biggest one, the SPDR S&P 500 ETF Trust, is relatively paltry compared with trading in individual stocks, Matthew Bartolini, State Street’s head of SPDR Americas research, said by email.

“I don’t feel short covering on SPY would have the intended effect to spur a rally in the broader market,” Mr. Bartolini said.