Funds Tracking REITs
Bet Against the House

Exchange-traded funds tracking real estate stocks have seen total assets surge, but that might not suggest a bullish call on the sector.

That's because ETF assets under management count short interest levels - speculative bets that stock prices will tumble.

REIT ETFs, which collectively have more than doubled assets so far this year, have high levels of short interest, said Louis Taylor, a real-estate industry analyst at Deutsche Bank Securities, Inc.

For example, the American Stock Exchange, home of most U.S. ETFs, said short interest in the StreetTracks Wilshire REIT fund represented 57.2% of total shares outstanding, and 124.6% for iShares Dow Jones U.S. Real Estate as of mid-April. Meanwhile, short interest for individual U.S. stocks averages about 2%.

Investors who sell short borrow shares from a broker with the intent of buying back the shares at a lower price. With indexed ETFs, the strategy can be used to speculate on a sector downturn or to hedge long portfolios.

"If intermediaries are buying shares to create ETFs to lend in short sales, that activity increases [ETF managers'] assets under management and the fund flows [reported by liquidity trackers]," Taylor said.

How REIT ETFs trade

The phenomenon underscores the fact that ETF trading can be different than for regular stocks, often in counterintuitive ways.

Large institutions and brokers are responsible for creating ETF shares, which they do by assembling baskets of the underlying stocks in the tracking index.

ETF shares are created in baskets called creation units, normally 50,000 shares, and individual shares can be thought of as "mini" index funds that trade on exchanges. ETF shares are created and redeemed "in kind" based on demand.

With real estate ETFs, the underlying securities are real estate investment trusts or REITs. Publicly-traded REITs are pools of capital that own and operate real estate. For example, Equity Office Properties is the largest owner of office properties in the U.S. with real estate in several major cities, while Equity Residential Properties is the biggest owner of apartment buildings.

When large numbers of investors short any ETF, institutions and brokers may be required to create new shares to lend, and short interest is included in ETF asset reports.

The latest-available figures show $223.9 billion invested in U.S. stock and bond ETFs at the end of February, according to the Investment Company Institute, the main trade group for mutual funds.

Almost $3 billion was held in the four U.S. real estate ETFs as of April 22. In order of size, they are: iShares Cohen & Steers Realty Majors, iShares Dow Jones U.S. Real Estate, StreetTracks Wilshire REIT and Vanguard REIT Index Vipers.

Having an opposite effect

Investors who short a stock are speculating on a price decline, which can put downward pressure on shares.

However, Taylor said shorting REIT ETFs can have the opposite effect if institutions need to buy the securities to create ETF shares.

"Short selling could push share prices up," he said.

Although difficult to measure, the impact could be even greater for REIT funds than for other ETFs because the REIT market isn't as liquid as markets for other large U.S. companies.

Yet Taylor noted two mitigating factors.

First, the amount of money invested in real estate ETFs is small compared to the overall capitalization of the REIT market.

Also, in creating new ETF shares, large institutions may not need to buy the underlying stocks if they already own them. This underscores another common misconception about ETFs: Bid/ask spreads tend to rely less on trading volume and more on the liquidity of the underlying shares.

For example, an ETF tracking the highly liquid Standard & Poor's 500 Index should have low trading spreads even on light volume days because institutions are more likely to have the shares on hand or can buy them without moving the market.

Email your comments to rjeditor@dowjones.com.